Forex and the carry trade: from the yen carry to Soros vs the pound
The foreign exchange market is the largest market in the world, trading several trillion dollars a day, around the clock from Monday morning in Asia to Friday evening in New York.
The basics
Currencies trade in pairs. GBP/USD at 1.30 means one pound buys 1.30 dollars. If it rises, the pound has strengthened. Most trading happens in the majors (EUR/USD, USD/JPY, GBP/USD) through banks and electronic platforms, with spot, forwards, swaps and options all heavily used.
What moves currencies: interest rate differentials, growth and inflation, trade and capital flows, and risk appetite. Some currencies (the yen, Swiss franc, US dollar) tend to strengthen in a crisis as money seeks safety.
The carry trade
Borrow in a currency with low interest rates, invest in one with high rates, and pocket the difference. For decades the yen was the classic funding currency because Japanese rates sat near zero.
Carry trades earn small, steady returns, often for years. The risk is the exchange rate. If the funding currency suddenly strengthens, losses can wipe out years of carry in days, and because the trade is crowded and leveraged, everyone heads for the exit at once. The pattern is often described as picking up pennies in front of a steamroller.
Case study: the yen carry unwind, August 2024
Years of near-zero Japanese rates had built up a huge yen carry trade. In late July 2024 the Bank of Japan raised rates, and on 2 August weak US jobs data raised expectations of Fed cuts. The rate gap that powered the trade was narrowing from both sides. The yen surged as positions were closed, and on 5 August Japan's Nikkei fell about 12% in a single day, its worst day since 1987. Volatility spiked globally before markets recovered within weeks.
Case study: Soros vs the pound, 1992
In 1992 the UK was in the European Exchange Rate Mechanism, committed to keeping the pound within a band against the Deutsche Mark. But German rates were high after reunification, and the UK was in recession. Keeping the peg meant high rates the British economy couldn't bear.
Stanley Druckenmiller, managing George Soros's Quantum Fund, concluded the peg would break. Soros pushed him to go bigger. The fund built a short position of around $10 billion against sterling. On 16 September 1992, Black Wednesday, the Bank of England bought pounds and raised rates from 10% to 12%, announcing a further rise to 15%, but couldn't stem the selling. That evening the UK left the ERM and the pound fell sharply. Quantum made around $1 billion.
The lesson traders took: when a policy is unsustainable, the market will eventually test it, and the asymmetry can be huge. If the peg held, the short lost little. If it broke, it paid enormously.
Key takeaway
Currencies are driven by rates and flows. Carry pays until it doesn't, and pegs hold until they don't. In both cases, positioning and leverage decide how violent the break is.
Educational content only, not financial advice. Options involve significant risk and are not suitable for everyone.