How does arbitrage trading make money? High-yield arbitrage strategies every investor must understand

In the past two years, whenever discussing the capital markets, the topic of carry trade cannot be avoided. Since the US Federal Reserve’s aggressive rate hikes in 2022, investors have started exploring profit opportunities from interest rate differentials across countries. However, many people are unclear about the difference between carry trade and arbitrage. Today, let’s clarify this financial lesson.

What is carry trade? Simply put, it’s making money by borrowing at low interest rates and investing in high-yield assets

Carry trade, in plain terms, is borrowing in currencies with low interest rates to invest in higher-yielding products, with the interest rate difference being your profit. Another way to say it is “interest rate arbitrage,” meaning exploiting opportunities for higher interest.

For example: In 2022, Taiwanese banks might borrow TWD at 2%, while USD fixed deposits offer 5%. Borrowing 1 million TWD to convert into USD and earn interest, the 3% difference is the annualized return. Sounds like a steady profit, right?

But reality isn’t that simple. Many assume that when interest rates rise, the currency will appreciate, so they boldly borrow to bet on it. Indeed, in 2022, exchanging TWD 1:29 for USD, by 2024, it became 1:32.6, so the same 100,000 USD principal can buy more TWD. However, there are counterexamples—Argentina, for instance, raised interest rates to nearly 100% (deposit 100 pesos, end of year 200 pesos), but this eroded confidence among citizens and foreign investors, causing the peso to depreciate by 30% daily.

So, raising interest rates does not necessarily mean the currency will appreciate; there are many complex factors behind it. Also, most carry trade players leverage to amplify profits, but if exchange rates move against them, losses can be doubled.

The 3 major risks of carry trade

To achieve stable profits from carry trade, you must first recognize these pitfalls:

1. Exchange rate risk

This is the most straightforward risk. Borrowing in a low-interest currency to invest in high-yield assets, if the exchange rate moves unfavorably, the currency loss can outweigh the interest gains.

2. Interest rate change risk

More subtle but more dangerous. Suppose you lock in a certain interest differential, but policy changes cause interest rates to narrow or even turn into losses. Taiwan’s insurance industry experienced this pain: years ago, selling fixed 6%-8% dividend policies when fixed deposits were 10%-13%, now fixed deposits are only 1%-2%, turning policies into heavy burdens. Borrowing to buy property is similar: initially expecting rental income > mortgage payments for arbitrage, but if mortgage rates rise or rentals decline, you might face immediate losses.

3. Liquidity risk

Finding yourself unable to exit when you want. Some financial products are easy to buy but hard to sell; items bought for 100 units might only be sellable at 90. Long-term contracts like insurance are even worse—only policyholders can cancel, and insurance companies have no obligation to unwind.

How to hedge these risks?

A common approach is using another financial product to offset risk. For example, a factory receives a 1 million USD order with delivery in one year. Currently, 1 million USD can be exchanged for 32.6 million TWD, but who knows what the exchange rate will be in a year? They can buy a forward FX contract (SWAP) to lock in the rate. This way, they neither gain nor lose from exchange rate fluctuations, mitigating risk.

However, practical operations incur costs—locking in the rate involves fees, and you can’t rely solely on exchange rate gains to offset. So most people don’t lock in the entire period; they usually hedge against uncontrollable factors (like holiday periods) or simply convert the investment back into the original currency to close the position.

The world’s largest carry trade: Yen arbitrage

Why is everyone rushing to borrow Japanese yen? Because Japan is one of the few developed countries with political stability, stable exchange rates, and extremely low interest rates, and yen is easy to borrow.

The Japanese government has maintained ultra-low or even negative interest rates for over twenty years to stimulate the economy, encouraging corporations and investors to borrow. Europe also experienced zero interest rates, but you rarely hear about borrowing euros for arbitrage because the Bank of Japan’s lending attitude is particularly relaxed.

Strategy 1: Borrow yen to invest in high-yield products

International traders first go to the Bank of Japan, using USD or domestic assets as collateral, borrow large amounts of low-interest yen or directly issue yen bonds at around 1%, then invest in high-interest currencies and financial products in the US, Europe, or even buy real estate. They use the dividends to pay interest, and repay principal early. Because yen borrowing costs are so low, even if the exchange rate moves unfavorably at maturity, the overall investment still yields a profit.

Strategy 2: Borrow yen to buy Japanese stocks

Warren Buffett has played a more daring game. After the global liquidity flood post-pandemic, he thought US stocks were too expensive, so he looked to Japan. He issued Berkshire Hathaway bonds in yen to borrow funds, then used the proceeds to buy Japanese blue-chip stocks. He then called for higher dividends and buybacks, and even protested at the Tokyo Stock Exchange, demanding listed companies increase liquidity, reduce cross-shareholdings, and keep stock prices above net asset value. Over two years, this strategy yielded over 50% profit. The clever part is no exchange rate risk—since he borrowed yen, invested in yen stocks, and earned dividend yields higher than bond interest, the profit comes from interest rate differentials.

Although many think borrowing to speculate in stocks is risky, for Buffett, the risk is extremely low because he can influence corporate boards. Unless companies are losing money, he generally profits.

Carry trade vs arbitrage: what’s the fundamental difference?

Arbitrage involves riskless profit—buy low and sell high across different exchanges or markets due to price, information, or regional differences.

Carry trade, on the other hand, involves investing in products with interest rate differentials, which inherently carries risks—exchange rate risk, interest rate risk, liquidity risk. That’s the core distinction.

How to make carry trade consistently profitable?

The key is timing. You need to understand how long you plan to hold the position to choose suitable arbitrage targets.

Next, analyze the historical price trends of your investment assets, preferably selecting those with predictable patterns. For example, USD/TWD often exhibits certain cyclical behaviors.

Therefore, to find good carry trade opportunities, investors should prepare charts of interest rate and exchange rate relationships across countries in advance. This helps ensure smooth execution of carry trades and reduces the risk of being caught off guard by exchange rate movements.