FX Carry Trades Explained: Strategies, Blowups, and Risk Management Tips

I used to do an FX carry trade that involved borrowing cheaply in yen or dollars and buying high-yielding, emerging market currencies.

I’d figured out what seemed like the holy grail of trading: borrow cheaply, invest in higher-yielding currencies, and pocket the difference. Every day, my account was credited with swap interest. It felt like getting paid while I slept.

The position kept working so well that I did what any overconfident beginner would do – I increased my size. Then, I increased it again. And again. Why waste such a golden opportunity?

What could possibly go wrong?

I’m sure you know where this is going.

To be honest, I can’t even remember what crisis it was that blew up my account. But it wasn’t even a major one.

Things turned “risk off” and the funding currencies strengthened while the EM currencies weakened. In less than a week, this account that had been steadily accruing profits became a financial black hole.

I learned the hard way what veteran traders mean when they describe carry trades as “picking up pennies in front of a steamroller.”

I want to share what I’ve learned about how carry trades actually work, when they make sense, and why they occasionally blow up spectacularly. This isn’t just academic. Understanding the mechanics behind carry trades offers lessons for the trader, even if you never explicitly put one on.

What Is a Carry Trade, Anyway?

At its core, an FX carry trade is embarrassingly simple: you borrow money in a low-interest currency and invest it in a higher-interest one.

The math looks straightforward:

• Borrow at 2% in Currency A
• Invest at 10% in Currency B
• Pocket the 8% difference as profit

If you’ve been paying attention to global interest rates, you’ll know that Japan has kept rates near zero for ages, while the US Federal Reserve has hiked rates recently. This creates a natural carry opportunity – borrow cheap in yen, invest in higher-yielding dollars.

Policy rates for Japan (blue) and the USA (maroon). Image: TradingView

A $100,000 position might earn you about $10 per day in interest alone. Multiply that by leverage, and it starts to look pretty attractive.

But there’s a massive catch.

According to economic theory (the “uncovered interest rate parity” theory, if you want to sound smart at dinner parties), currency exchange rates should adjust to offset interest rate differences. In other words, high-interest currencies should depreciate against low-interest ones by roughly the rate differential.

If that were always true, carry trades wouldn’t work. You’d gain 4.5% on interest but lose 4.5% on the exchange rate.

But here’s the beautiful market inefficiency: this theoretical relationship often breaks down in practice. High-yield currencies don’t seem to depreciate as much as theory predicts. Sometimes they even strengthen, giving carry traders a double win – interest spread plus currency appreciation.

This inefficiency is why carry trades have been a staple strategy for decades. But it’s also why they periodically blow up spectacularly.

When Carry Trades Work: The Staircase Up

Carry trades thrive in “risk-on” environments. When markets are calm, economic growth is stable, and investors feel confident, money flows steadily into higher-yielding assets.

During these periods, high-interest currencies often hold their value or even appreciate as capital flows in. This allows carry traders to quietly collect their interest spread month after month, with the occasional bonus of currency appreciation.

Picture the heyday of carry trades in the mid-2000s. Global markets were buoyant, volatility was low, and interest rate differentials were substantial. Traders borrowing in Japanese yen at near-zero rates and investing in Australian dollars yielding 5%+ made consistent profits.

Returns to being long Australian dollar futures, short yen futures 2002-2008. Image: TradingView

During these periods, profits accumulate steadily – like walking up a staircase, one step at a time. The trade feels safe, predictable, even boring.

But this predictability is precisely what makes carry trades dangerous.

When Carry Trades Explode: The Elevator Down

The fundamental vulnerability of any carry trade is a sudden reversal in risk sentiment. When markets panic – due to a financial crisis, recession fears, geopolitical shock, or other black swan events – the dynamics that support carry trades break down violently.

In risk-off episodes:

1. Investors flee high-yield assets for safety
2. Low-interest “funding” currencies (like JPY or CHF) suddenly strengthen
3. High-yield target currencies plummet
4. Leveraged positions face margin calls, forcing more selling
5. The vicious cycle accelerates

This creates what academics call “negative skew” in returns – long periods of steady gains punctuated by sudden, catastrophic losses. As traders say, carry trades “go up by the stairs and down by the elevator.”

Returns to being long Australian dollar futures, short yen futures 2003-2009. Image: TradingView

Let’s look at two spectacular carry trade blow-ups:

The 2008 Global Financial Crisis

Prior to 2008, the yen carry trade had swelled to an estimated $1 trillion. Investors everywhere were short yen and long higher-yielding currencies and assets.

When Lehman Brothers collapsed and the financial crisis spread, these positions unwound en masse. The Japanese yen – previously the cheap funding currency – surged against a basket of carry-trade target currencies in 2008.

Years of steady carry profits were obliterated in weeks. Traders who had grown accustomed to the “free money” suddenly faced devastating losses that far exceeded their accumulated interest gains.

The yen’s surge actually amplified the broader market panic. As carry traders desperately unwound positions, they were forced to sell other assets to cover losses, contributing to the global sell-off. Of course, there were other things contributing to the sell-off, but you can see how these things can become a self-reinforcing loop.

The March 2020 COVID Panic

A similar scenario played out during the initial COVID shock. Before the pandemic, many traders were long higher-yielding currencies funded by lower-yielding ones. Perhaps just enough time had passed for the carry nightmare of 2008 to recede from the mind.

As COVID fears triggered a global dash for cash and safety, funding currencies spiked while target currencies plummeted. The Australian dollar, Mexican peso, and other carry targets fell dramatically.

In these moments, the market enters a liquidity black hole. Everyone rushes for the exits simultaneously, but buyers disappear. Prices gap lower as stop-losses trigger, forcing more selling in a cascade effect.

What makes these episodes so dangerous is their self-reinforcing nature. The very act of unwinding carry trades accelerates the moves that make them unprofitable. It’s like a financial avalanche – once it starts, it’s nearly impossible to stop until it runs its course.

The Hidden Risk Premium

After reading about these blow-ups, you might wonder why anyone would touch carry trades with a ten-foot pole. But there’s a method to the madness.

The periodic crashes aren’t a bug in the carry trade system – they’re a feature. These crashes are precisely why carry trades generate positive expected returns over time.

Think about it: why would markets consistently allow an “arbitrage” where you simply pocket interest rate differentials? The answer is that it’s not a free lunch. The carry trader is effectively selling crash insurance. You collect small premiums (the interest differential) but occasionally have to pay out a massive claim (during market panics).

This is why carry strategies can make sense to the trader prepared to take on that risk and manage it well.

It’s conceptually similar to selling options or investing in other risk premia. You earn steady returns most of the time as compensation for occasionally getting absolutely hammered.

Managing Carry Trade Risk: Not All Carry Is Created Equal

If you’re still interested in carry trading after all those warnings, here are some approaches to help manage it:

1. Position Sizing (primary defense)

The quickest way to blow up with carry trades is excessive position size.

Sensible position sizing is critical. Don’t size these things based on their performance in benign periods. Take into account the negative skew (outsized negative returns).

Position sizing is your first and most important risk management tool.

2. Volatility-Adjusted Carry (somewhat helpful)

Not all high-yield currencies are created equal. Some are far more volatile than others, making their carry-to-risk ratio less attractive.

Instead of chasing the absolute highest yield, look at the interest rate spread relative to the currency’s volatility – essentially a Sharpe ratio for carry. A 4% yield in a relatively stable currency might be preferable to an 8% yield in an extremely volatile one.

For example, at various points historically, the Mexican peso has offered high interest rates but with substantial volatility, while the Singapore dollar has offered moderate rates with much lower volatility. The higher-quality carry might be able to provide better risk-adjusted returns.

3. Diversify Funding Sources (tends to abandon you when you need it most, but still worth doing)

One of the biggest risks in carry trades is that your funding currency (the one you’re short) spikes during market stress. To mitigate this, avoid putting all your eggs in one funding basket.

Instead of funding everything with yen or Swiss francs, consider a basket of low-yield currencies. This reduces your exposure to any single funding currency’s movements.

Having said that, be aware that the benefits of diversification will typically desert you just when you need them most. In times of crisis, these things will all become highly correlated.

The following chart makes this real. It shows the Australian dollar against three funding currencies (JPY, CHF, USD) on either side of the GFC. Note that there’s genuine diversification on either side of the crisis period, and how they all moved together when things went bad.

AUD versus funding currencies – yen (blue), Swiss franc (green), USD (orange) around the GFC. Image: TradingView

4. Watch the Crowd (marginal benefit)

Carry trades become most dangerous when they’re crowded. When “everyone” is in the same trade, the exit becomes a bottleneck during a reversal.

Extreme speculative positioning in currency futures or options markets can signal heightened risk. When carry trades become consensus, it might be time to reduce exposure.

Don’t rely on this to save you, though. It might provide some discretionary view on when to lighten up, but the reality is that there just aren’t enough data points to create an evidence-based systematic signal for getting out of the carry trade based on positioning data.

5. Trend Filters (possibly of marginal benefit)

I used to do a carry trade where I essentially trend-followed the strategy’s equity curve. My research suggested that carry returns were (very) noisily correlated with past carry returns.

Don’t rely on this to save you, though. Don’t think that you can use it to sidestep one of those disasters that certainly lie in the future. At best, it might give you some benefit at the margins.

Practical Implementation for Retail Traders

If you’re a retail trader interested in carry, here are some practical approaches:

Spot FX Trades

The most straightforward method is using a forex broker to hold positions in your chosen currency pair. For example, buying USD/JPY to capture the US-Japan interest differential.

Most retail FX brokers will pay or charge overnight swap rates that reflect the interest differential between currencies. If you go long a pair where the base currency has a higher interest rate than the quote currency, you’ll typically earn positive rollover interest each day.

Your broker’s platform should display the daily swap rates for each currency pair. These rates change, so keep an eye on them.

Your broker will put a spread on the swap rate you’re credited or debited with, essentially taking a cut on both sides. You’ll want to do some research and figure out whether the trade is worth your while in the face of these costs.

Moderation Is Key

Start small with carry trades. Take both volatility and skew into account when sizing positions.

And like most edges available to retail traders, remember that carry is noisy. Don’t expect it to shoot the lights out – treat it as one small part of a bigger portfolio.

Monitor Global Risk Sentiment (but don’t expect this to save you)

Carry trades are essentially risk-on positions, so pay attention to broad market sentiment indicators. Spikes in the VIX volatility index, sharp equity market declines, or emerging geopolitical tensions can all signal potential trouble for carry positions.

Unfortunately, by the time these indicators are flashing red, your carry trade has already been whacked. Position sizing is your first defense.

Real-World Examples: Classic Carry Pairs

Over the years, certain currency pairs have become synonymous with carry trading. Here are some classics:

AUD/JPY and NZD/JPY

The Australian and New Zealand dollars have historically offered relatively high interest rates due to their commodity-driven economies and inflation-conscious central banks. Paired against the perpetually low-yielding Japanese yen, these crosses became known as premier carry trades in the 2000s.

During the pre-2008 period, the Australian dollar was dubbed the “King of the Carry” due to its relatively high interest rates, strong credit rating, and stable economy. AUD/JPY was the quintessential carry trade for years.

USD/JPY

The USD/JPY relationship has evolved over time. In the 1990s-2000s, the yen was typically the funding currency and USD the higher-yield target. This fell away during the low-interest-rate years in the US.

Most recently, as the Fed has hiked rates while the Bank of Japan maintained ultra-loose policy, USD/JPY has again become a potential carry trade, with an interest differential to going long dollars against yen.

Emerging Market Carries

Emerging market currencies have offered even juicier carry opportunities. Currencies like the Mexican peso (MXN), Brazilian real (BRL), South African rand (ZAR), or Turkish lira (TRY) have often carried interest rates in the high single-digits or even double-digits.

These emerging market carries amplify both the potential returns and the risks. A U.S.-based investor borrowing yen at ~0% and buying Mexican peso bonds yielding ~7-10% stood to gain substantially – provided the peso held its value.

Of course, the downside risk is also amplified. The Turkish lira was once a darling of carry traders thanks to Turkey’s high interest rates, but political instability and inflation eventually led to currency collapse, devastating those positions. It was the exact opposite of free money.

Final Thoughts: A Respectable Strategy With Real Risks

Carry trades remain a fundamental strategy in currency markets, allowing traders to profit from global interest rate imbalances. Despite the risks I’ve outlined, decades of both real-world experience and academic research have established that the carry premium is real – high-interest currencies tend to offer excess returns on average.

Many successful traders have harvested this premium, usually with robust risk controls in place. Many have also blown up. The key is understanding what you’re getting into.

You’re not just collecting “free money” from interest rate differentials. You’re being compensated for providing liquidity and taking on the risk of potentially devastating losses during market dislocations.

If you approach carry with this mindset – respecting the steamroller while still picking up those pennies – it can be a valuable component of a diversified trading approach.