Carry Trade Mechanics and Risks

What Is a Carry Trade?

A carry trade involves borrowing in a low-interest-rate currency and investing the proceeds in a higher-interest-rate currency. The profit comes from the interest rate differential, called the "carry," assuming exchange rates remain stable.

The strategy exploits uncovered interest parity violations. In theory, high-yield currencies should depreciate against low-yield currencies by exactly the interest rate differential, eliminating arbitrage profits. In practice, this relationship doesn't hold consistently, creating profit opportunities—and risks.

Basic Mechanics

Consider a classic carry trade using Japanese yen and Australian dollar:

Setup:

• Borrow JPY at 0.5% annual interest
• Convert to AUD at current spot rate (assume 95 JPY per AUD)
• Invest in AUD at 4.5% annual yield

Annual carry = 4.5% - 0.5% = 4.0%

If the exchange rate remains unchanged after one year, the trader earns 4.0% return before transaction costs. This return requires no fundamental analysis or directional view—just stable exchange rates.

The Full P&L Calculation

Total return on a carry trade has two components:

Total Return = Carry Return + Currency Return

If AUD appreciates 2% against JPY: Total return = 4.0% + 2.0% = 6.0%

If AUD depreciates 2% against JPY: Total return = 4.0% - 2.0% = 2.0%

If AUD depreciates 6% against JPY: Total return = 4.0% - 6.0% = -2.0%

The asymmetry is clear: currency moves can easily overwhelm the carry income.

Leverage and Position Sizing

Carry trades typically use leverage because unleveraged returns are modest:

Higher leverage amplifies returns but also amplifies currency risk:

Example with 10x leverage:

• $100,000 capital controls $1,000,000 AUD/JPY position
• 4.0% carry on $1,000,000 = $40,000 annual income (40% return on capital)
• 5% adverse currency move = $50,000 loss (50% of capital)

Many carry trade blowups occur when leverage meets unexpected currency volatility.

Worked Example: Full P&L Scenarios

Trade setup:

• Capital: $100,000
• Leverage: 5x ($500,000 notional)
• Position: Long AUD/JPY
• Entry rate: 95.00
• Carry: 4.0% annually
• Holding period: 6 months

Scenario 1: Stable markets

• Exit rate: 95.50 (AUD +0.5%)
• Currency gain: $500,000 x 0.5% = $2,500
• Carry income (6 months): $500,000 x 4.0% x 0.5 = $10,000
• Total P&L: $12,500 (12.5% return on capital)

Scenario 2: Risk-off event

• Exit rate: 85.50 (AUD -10%)
• Currency loss: $500,000 x 10% = $50,000
• Carry income (6 months): $10,000
• Total P&L: -$40,000 (40% loss on capital)

Scenario 3: Crisis unwind

• Exit rate: 76.00 (AUD -20%)
• Currency loss: $500,000 x 20% = $100,000
• Carry income (6 months): $10,000
• Total P&L: -$90,000 (90% loss on capital)

The math demonstrates why carry trades are sometimes described as "picking up pennies in front of a steamroller." Small, steady gains accumulate until a sudden currency move wipes out months or years of carry income.

Carry Trade Unwinds

Carry trades exhibit a characteristic risk pattern: gradual accumulation of gains followed by rapid losses during risk-off periods.

Why Unwinds Are Violent

Several factors create explosive reversals:

Crowded positioning: When many traders hold similar carry positions, exit attempts create one-way markets. Selling pressure drives the high-yield currency down further, triggering more stops and exits.

Leverage forced liquidation: As positions move against leveraged traders, margin calls force selling at the worst possible time. This creates cascading liquidations.

Volatility feedback: Rising volatility increases margin requirements and risk model signals, prompting further position reduction.

Liquidity withdrawal: Market makers widen spreads and reduce quote sizes during volatility, making exits more costly.

Historical Unwind Events

The August 2024 unwind is particularly instructive. After years of near-zero Japanese rates, the Bank of Japan began raising rates while global risk sentiment weakened. JPY strengthened rapidly as carry traders rushed to exit, with AUD/JPY falling over 12% in days.

VIX Correlation

Carry trade performance correlates inversely with the VIX volatility index:

• VIX below 15: Generally favorable for carry trades; low volatility, stable currencies
• VIX 15-25: Mixed conditions; currency volatility increases
• VIX above 25: Typically negative for carry; risk-off flows strengthen funding currencies
• VIX above 30: Carry trade losses often accelerate; crisis conditions

This correlation isn't perfect, but it reflects the underlying dynamic: carry trades profit during calm markets and suffer during stress. The VIX serves as a proxy for global risk appetite.

Monitoring Carry Trade Risk

Traders watch several indicators:

• VIX level and trend
• JPY and CHF strength (funding currency appreciation)
• EM currency weakness
• Credit spreads widening
• Equity market volatility
• Central bank policy signals (especially BoJ)
• Positioning data (CFTC futures data)

Risk Management for Carry Trades

Given the asymmetric risk profile, careful risk management is essential:

Position sizing: Size positions assuming the worst-case currency move, not the expected case. A 15-20% adverse move should not threaten portfolio survival.

Stop losses: Define exit points before entry. Mechanical stops prevent behavioral biases during rapid moves, though slippage in fast markets means actual exits may be worse than planned.

Volatility scaling: Reduce position size when implied volatility rises. If normal AUD/JPY volatility is 10% and current implied volatility is 15%, consider reducing position by one-third.

Diversification: Spread carry exposure across currency pairs with different characteristics. MXN/JPY and BRL/USD may have similar carry but different risk drivers.

Hedging with options: Buy downside puts on high-yield currencies or calls on funding currencies. This reduces carry income but limits catastrophic losses.

Who Uses Carry Trades?

Hedge funds: Systematic macro funds often run carry as one component of diversified currency strategies.

Banks' proprietary desks: Before regulatory restrictions, banks actively traded carry.

Retail FX traders: Accessible through leveraged FX brokers, though many retail traders underestimate the risks.

Pension funds and insurers: Some use carry overlays on international portfolios, typically with lower leverage.

Corporations: Not carry trades per se, but companies with foreign currency revenues effectively earn carry when they delay repatriation.

The Bottom Line on Carry

Carry trades can generate consistent returns during stable periods, but the risk profile is asymmetric. Gains accumulate slowly through interest rate differentials; losses can occur rapidly through currency moves.

The strategy works best when:

• Global volatility is low
• Interest rate differentials are wide
• Funding currency central banks are dovish
• Risk appetite is stable or improving

The strategy fails when:

• Risk-off events trigger funding currency strength
• Positions become crowded
• Central banks shift policy unexpectedly
• Global volatility spikes

For most investors, carry trades represent a tactical opportunity rather than a core holding. Understanding the mechanics helps evaluate whether current conditions favor the strategy—and when to step aside.