The currency carry trade: borrowing low to invest high and the risks involved
The currency carry trade is one of the most studied systematic strategies in foreign exchange markets. It involves borrowing in a low-interest-rate currency and investing the proceeds in a high-interest-rate currency, earning the interest rate differential as return—provided the exchange rate does not move enough to offset it. The carry trade has historically produced positive average returns, but those returns come with a characteristic risk: occasional sharp and rapid reversals that can wipe out months of accumulated carry in days.
What the currency carry trade is
The theoretical basis of the carry trade rests on the violation of uncovered interest rate parity (UIP). UIP predicts that high-interest-rate currencies should depreciate over time to offset the interest rate advantage, leaving investors indifferent between holding either currency. If UIP held perfectly, carry trades would earn zero expected return. But empirical evidence has consistently shown that UIP does not hold in practice: high-interest-rate currencies do not systematically depreciate by the amount predicted, and carry trades have historically delivered positive average returns across a wide range of currencies and time periods.
The most commonly cited carry pair is borrowing in Japanese yen (historically a very low-rate currency) and investing in currencies such as the Australian dollar or emerging market currencies with higher interest rates. At its peak in 2006–2007, the yen carry trade was estimated to involve notional positions of several trillion dollars, making it a significant force in currency markets.
How it works
In practice, a carry trade investor does not need to literally borrow in one currency and invest in another. The same economic exposure can be achieved through currency forward contracts: buying a high-rate currency forward and selling a low-rate currency forward locks in the interest rate differential as the difference between the spot rate and the forward rate. This is why the carry trade is also described as going long the currencies with higher forward premiums and short the currencies with lower forward premiums.
The carry return has two components. The first is the interest rate differential itself—the direct income from the rate difference between the funding currency and the investment currency. The second is the spot return: any appreciation of the investment currency against the funding currency adds to the total return, and depreciation subtracts from it. A carry trade can be profitable even if the investment currency depreciates slightly, provided the depreciation is less than the interest rate differential.
Carry strategies are often implemented systematically across a basket of currencies rather than a single pair, which diversifies idiosyncratic currency risk. A typical systematic carry strategy goes long the highest-yielding currencies in a universe (say, the top third by interest rate) and short the lowest-yielding currencies (the bottom third), rebalancing periodically as relative interest rates change.
What the evidence shows
The academic literature on currency carry returns is extensive. Research by Lustig and Verdelhan (2007) in the Journal of Finance, covering the period 1953–2002, documented significant and persistent excess returns from carry strategies across developed market currencies. Subsequent research extended these findings to emerging market currencies and confirmed the robustness of the basic result: carry strategies deliver positive average returns, but with pronounced negative skewness—long periods of gradual gains punctuated by sharp drawdowns.
The explanation most widely accepted in the academic literature is that carry returns represent compensation for a specific type of risk: funding liquidity risk and crash risk. Carry strategies tend to perform poorly precisely when broader financial markets are under stress, when investors de-risk rapidly, and when funding markets seize up. This co-movement with broad financial risk means that carry returns are not truly diversifying—they are collected in calm conditions and given back during crises, often amplified by crowding.
Limitations and trade-offs
The crash risk in carry strategies is severe and has been repeatedly demonstrated. In 2008, the unwinding of the yen carry trade contributed to a rapid appreciation of the yen of more than 30% against the Australian dollar over a period of weeks, as leveraged carry positions were liquidated simultaneously. Investors who had accumulated carry returns over several years saw much of those returns erased in a short period.
Transaction costs matter more for carry strategies than for buy-and-hold equity investments. Frequent rebalancing across multiple currency pairs, the bid-ask spreads in FX markets, and roll costs on forward contracts all reduce the net return. Gross carry returns in the academic literature overstate what is achievable in practice, particularly at scale.
The carry trade also tends to become more crowded and more risky as it becomes better known. When a large number of investors simultaneously hold the same carry positions, the potential for a disorderly unwind—if market conditions deteriorate—increases. This crowding risk is difficult to quantify in advance.
The carry trade in pfolio
Currency carry is one of several systematic return drivers accessible through the Currency asset class in pfolio. It can be expressed through currency instruments directly or through the broader portfolio construction framework. The Currency asset class in pfolio is described in currency investing, and related instruments are available in the Assets section. Currency performance data, including returns attributable to carry positions, is tracked in pfolio Insights.
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