Traders borrow in currencies with low interest rates and invest in currencies with high interest rates profiting from the margin. Prior to the global financial crisis, carry trades in Yen and commodity currencies were common. In the recent past, with accommodative monetary policies and near zero interest environments in developed economies, currencies of EMEs have emerged as avenues of carry trade.
The problem with currency carry trades is that they are inherently unstable. The initial buying of the high yielding currency has the perverse effect of pushing the currency higher, giving the impression of unidirectional bias and complicating policy for the country as the overvalued exchange rate dents the country’s export competitiveness.