The uncovered interest rate parity says high-yield currencies should depreciate and low-yield currencies should appreciate. The change in spot rates should cancel out the interest rate differentials so there should be no arbitrage profit.

However, various studies have found that high-yield currencies have not depreciated to the levels predicted by interest rate differentials, and low-yield currencies have not appreciated that much either.

The strategy of carry trade is to long high-yield currencies and short low-yield currencies.

Example

Assume that the U.S. T-bills yield 4.5% a year, and Japanese risk-free bonds yield 0.5% a year. The current spot rate is 80Yen/$. If you short Yen 80,000 Japanese bonds (i.e., borrow Yen 80,000 at 0.5% per year), and use the proceeds of $1,000 to buy U.S. T-bills. One year later the exchange rate becomes 78 Yen/$ (the $ has depreciated but not by that much).

You will get $1,045 from your U.S. T-bill investment. That is Yen 81,510 (1,045 x 78). You also need to pay back 80,000 x 1.005 = Yen 80,400. Your net profit will be Yen 1,110.

The biggest risk of this strategy is the uncertainty of exchange rates. What if the $ depreciates more than 4%? A small change in the exchange rate could potential cause a big loss, especially many transactions are done with a lot of leverage.