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I understand the carry trade mechanism, but I wonder why it works, or why it doesn't work.

Each currency has an interest rate associated with it. The Yen (JPY) has historically had a very low interest rate, while the Australian Dollar (AUD) has one of the highest rates in the world.

Borrowing an amount in a low-interest currency, exchanging that amount to a high-interest currency, and investing it in bonds (or some other instrument) in order to profit from the difference in interest rates is known as the carry trade.

By engaging in the carry trade you are exposed to a currency risk. This manifests itself when the time comes to pay back the loan.

The currency carry trade sounds like free money, and the promise of free money is usually a tell-tale for disaster. Why won't arbitrage mechanisms cause the high-yielding currency to continuously devalue against the low-yielding currency, essentially negating any profits from the interest differential?

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As you say, the currency carry trade shouldn't work. The deluge of new cash into a high-interest currency should result in falling exchange rates.

A November 2009 paper by Òscar Jordà and Alan Taylor of the University of California, Davis, may be offer one approach which is more stable.

According to The Economist:

They find that a refined carry-trade strategy—one that incorporates a measure of long-term value—produces more consistent profits and is less prone to huge losses than one that targets the highest yield.

However, exchange rates, central bank interest rates, as well as money supply are all political as well as economic constructs. An economic driver for arbitrage may be offset by political will (such as US quantative easing) or even social malaise (Japanese continual low inward investment).

I wouldn't go so far as calling the carry trade "free money" - currencies have proven far too unstable for that - but state interference in markets tends to be clearly telegraphed and a trader with nerves of steel may take advantage of it.

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In addition to the accepted answer, I want to extend your setup. After buying the bond you'd simultaneously enter into a forward contract, termed on the maturity of the bond exchanging the face value and interest back to the currency you borrowed.

This way you eliminated currency risk at the expense of counterparty risk. The difference you will see (and earn) is the risk premium for holding the bond.

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