Carry Trades and Their Risk Profile

Carry trades earn a steady interest rate spread most of the time and lose a large multiple of it during funding currency unwinds.

A carry trade borrows in a currency with a low interest rate and invests the proceeds in a currency with a higher interest rate, collecting the rate differential as long as the exchange rate does not move against the position by more than that differential. The strategy looks like steady income in calm markets and behaves like a short volatility position in stressed ones, because the currencies that typically fund carry trades tend to appreciate sharply exactly when risk appetite collapses.

A trader executing a carry trade borrows, or takes a short forward position in, a low-yielding currency such as the Japanese yen, converts to a higher-yielding currency such as the Australian dollar or a target emerging market currency, and holds the position for the interest rate spread. The trade earns its return primarily as a running yield, provided the exchange rate stays roughly stable or drifts in the investor's favor. Covered interest parity means the forward market prices in most of the differential upfront, so a pure carry trade relies on the gap between the forward rate's prediction and the spot rate that eventually materializes.

This is the important nuance: if covered interest parity held perfectly, carry trades would earn nothing on average, because the forward discount on the high-yield currency would exactly offset the extra interest earned. The historical evidence, going back decades, shows the forward rate is a biased predictor of the future spot rate, and high-yield currencies have on average outperformed what the forward market predicted, which is the empirical basis for the carry trade's positive average return, sometimes called the forward premium puzzle.

The Japanese yen and, at various points, the Swiss franc have served as classic funding currencies because both economies have run persistently low interest rates and both currencies tend to strengthen during periods of global risk aversion, which is precisely when carry trades are being unwound and funding currencies are being bought back to close short positions.

This creates a feedback loop. A shock that makes carry trades less attractive causes funding currency buying, which strengthens the funding currency, which increases the loss on any remaining short funding currency positions, which triggers more unwinding. The loop can move quickly once it starts, because it is largely mechanical rather than driven by new information about interest rate differentials.