Definition, How It Works, Example, and Risks

“A welcome period of relative stability in global markets has been upended by a sudden plunge in stock prices.” So begins a 2024 World Economic Forum report on the effects of major shifts in carry trades that year. This highlights the often overlooked yet powerful influence of these financial maneuvers on global financial markets.

In general, a carry trade is any strategy where an investor borrows capital at a lower interest rate to invest in assets with potentially higher returns. However, it’s best known for its use in foreign exchange (forex or FX) markets, where it’s defined as borrowing in a low-interest rate currency and investing in higher-yielding assets denominated in another currency, aiming to profit from the spread.

Consider the yen carry trading of the 2000s: It became so popular that it was estimated to account for up to a fifth of the daily turnover in currency markets. With near-zero interest rates, investors borrowed cheaply in Japanese yen and poured money into higher-yielding assets abroad. This massive flow of capital affected exchange rates and influenced asset prices globally.

The 2024 carry trade unwinding serves as a stark reminder that in the interconnected world of global finance, events in one market can rapidly ripple across the globe. In the following sections, we’ll explore the potential benefits and inherent risks of carry trades, their impact on global financial markets, what researchers say about where profits come from in this area, and then use the 2024 market drop as an illustration of the far-reaching effects of these trades.

Understanding Carry Trades

Carry trades attempt to exploit differences in interest rates from central banks relating to two currencies. In carry trades, investors borrow money in a low-interest-rate currency (the funding currency) and use it to invest in high-yielding assets denominated in another currency (the target currency). Though we’ll complicate this depiction in a moment, the goal is to profit from the interest rate differential and potential appreciation of the target currency.

For example, an investor might borrow Japanese yen (JPY) at a 0.1% interest rate to buy U.S. Treasury bonds yielding 4%. The investor profits from the 3.9% difference if exchange rates stay about the same.

Historically, popular carry trade pairs have included borrowing in Japanese yen or Swiss francs (low-interest currencies) to invest in higher-interest currencies, whether the U.S. dollar, Mexican peso, or Australian dollar. However, the specific currencies involved depend on global economic conditions and monetary policies.

While individual investors engage in carry trades, they are more common with large institutional investors, hedge funds, and forex traders who can manage the risks.

The Gap Between Theory and Practice in Carry Trades

The typical, simple depiction of carry trades as profiting from interest rate differences leaves out how, broadly speaking, this strategy capitalizes on the idea that capital tends to flow toward countries offering higher real returns—that is, interest rates minus the rate of inflation.

This requires some explanation. In practice, most carry traders don’t physically exchange currencies. Instead, they perform their strategy using futures or forward currency markets, where they can borrow (use leverage) to boost their potential returns. When traders look for interest rate differences between countries, these should be reflected in the forward exchange rates because of interest rate parity, a fundamental concept in international finance.

Interest rate parity suggests that the difference in interest rates between two countries should be reflected in the forward exchange rates between their currencies. For instance, if the U.S. has higher interest rates than Japan, the forward exchange rate for USD/JPY should be proportionally higher than the spot rate (the present market price) to make up the difference.

Thus, in theory, adjustments made within the forward or futures markets should prevent risk-free arbitrage, that is, profiting by simultaneously buying and selling an asset in different markets without any market risk. But there’s no such thing as a secret in public markets. If you could borrow in a low-interest currency, convert to a high-interest currency, invest at the higher rate, and then use a forward contract to eliminate your exchange rate risk, everyone would do it. The forward rate is supposed to adjust to make this impossible—at least in theory.

Profiting From Forward Bias

And yet it happens as carry traders exploit a persistent market anomaly known as the “forward premium puzzle” or “forward bias.” Despite what interest rate parity predicts, currencies with higher interest rates often appreciate more or depreciate less than the forward rates imply.

Hence, traders aim to gain not just from the interest rate differences but from any deviation between the actual exchange rate movement and what the forward rates predicted. This complexity makes carry trades potentially lucrative and inherently risky, especially since when these markets shift, they do so rapidly.

This brings us to the phenomenon known as “forward bias.” Although the interest rate differential should be (at least theoretically) already priced into the forward exchange rate, researchers and practitioners have noticed that currencies with higher interest rates tend historically to appreciate more than they should against lower-yielding currencies over time. This trend persists as long as the higher-yielding country maintains economic stability and manageable inflation.

Researchers have various surmises for why this is the case—stability and safety tipping the market toward risk aversion being chief among them—but the point is that it’s there. This means that capital tends to flow toward higher-yielding markets, assuming relative economic stability.

For example, traders might expect (using hypothetical percentages) the U.S. dollar (yielding 4%) to strengthen against the Japanese yen (yielding 0.1%), or the Brazilian real (yielding 8%) to appreciate versus the U.S. dollar, provided Brazil maintains economic stability and keeps inflation in check.

Traders exploit this bias by taking positions in currency futures or forward markets. For instance, if U.S. interest rates are higher than Japanese rates, a carry trader might buy USD/JPY futures contracts, effectively betting that the dollar will strengthen against the yen. The trader profits if the actual exchange changes exceed the interest rate differences already priced into the forward rate.

What the Research Says About Profits in Carry Trades

For those who wish to dig a bit deeper into this puzzle, it’s good to quickly review what academics and practitioners have said. First, reviewing decades of data on carry trades, they repeatedly find a risk premium, despite efficient market theories leading one to believe that, all things being equal, the tendency for high-interest currencies to appreciate more (or depreciate less) than what interest rate parity would predict shouldn’t exist.

Here are some explanations given for this:

1. Risk premia: Investors may demand more to hold certain currencies, beyond interest rate differentials. This could be because of perceived economic or political risks that can’t be priced into simple interest rate differences. However, this is just another way of restating the puzzle, not answering why it exists.
2. Central bank policies: Interventions or anticipated policy changes can influence currency demand in ways not captured by interest rates alone.
3. Institutional factors: Similarly, large institutions may have specific needs or mandates that cause them to buy or sell currencies in patterns that don’t align with interest rate parity.
4. Behavioral factors: Investors engage in herding behavior or overreact to certain types of news, creating persistent biases in currency flows.
5. Market microstructures: The way trades are executed and information flows through the market creates persistent patterns in order flow (supply and demand). A 2024 study, updating previous work, makes the vital contribution of showing that forward bias only exists in specific markets (mainly when interest rate differentials are positive) and isn’t a universally applicable rule. This is crucial for investors involved in carry trades to understand.
6. Global imbalances: Long-term capital flows because of trade imbalances or investment patterns often put sustained pressure on certain currencies.
7. Negative interest rate differentials correlate to crisis periods: When the typically higher interest rate currency goes lower than the other, these tend to be during economic and market crises. At these moments, there tends to be a flight to security, and the forward bias reverses itself.
8. When carry trade regimes change, events move fast: Studies find that transitions between positive and negative interest rate differential regimes are frequently abrupt. This implies that, in practice, snap shifts are the rule, not the exception.

The research on carry trades thus highlights the complexity of currency markets and suggests different factors drive currency moves depending on the economic conditions. Together, the data challenges the notion that carry trades consistently explain deviations from interest rate parity, particularly during market stress or when interest rate differentials are negative.

This is crucial to understand for those wanting to navigate the intricacies of international currency markets. Otherwise, you’ll be unready for the forward bias to suddenly reverse itself, with disastrous results if you’re among those unable to get out of the market in time. This brings us to the risks of carry trading.

Carry Trade Risks

The strategy can be—in fact, for many international traders, has been—highly profitable during periods of market calm and stable economic conditions. However, carry trading is vulnerable to sudden market shifts, especially when the funding currencies (typically low-yielding “safe havens” like the yen or Swiss franc) appreciate rapidly, potentially wiping out months or years of accumulated carry profits.

Here are some of the risks faced by carry traders:

• Interest rate changes: Carry trades rely on interest rate differentials remaining stable. If the central bank of the funding currency raises rates or the target currency’s central bank lowers rates, the profit margin can shrink or disappear. This is precisely what was at issue, for example, in the carry trade unwinding of 2024.
• Exchange rate risk: This is the most significant factor affecting carry trades. If the funding currency appreciates against the target currency, it can quickly wipe out any gains from the interest rate differences.
• Market sentiment shifts: Carry trades can become crowded, with many investors pursuing the same strategy. This can lead to rapid, self-reinforcing movements when market sentiment shifts in the other direction.
• Devaluation risk: While this still occurs, it was a more prominent risk in previous decades. Emerging market currencies, often targets for carry trades because of their higher interest rates, can have sudden devaluations, usually driven by a nation’s central bank. While higher rates might suggest currency strength, hyperinflation or political unrest leads to rapid depreciation.
• Volatility: Increased volatility in local equity markets or capital outflows can spread, causing currency troubles.
• Changes in economic indicators: Inflation rates, gross domestic product growth, and trade balances can influence currency values and interest rates, impacting the profitability of carry trades.
• Economic shocks: Unforeseen events can cause sudden currency fluctuations, leaving traders with significant losses before they can exit their positions.

Beyond individual traders, when the following happens, entire markets are put at risk:

• Liquidity black holes: During periods of extreme market stress, such as the 2008 financial crisis or the early pandemic, liquidity can vanish almost entirely. Financial researchers have dubbed certain of these moments “liquidity black holes” because while lower prices are supposed to attract more buyers, at these times, what’s generated are more sellers. This is particularly dangerous for those in carry trades as traders rush to unwind positions simultaneously, exacerbating price movements.
• Safe haven flows: In times of crisis, there’s often a flight to safe-haven assets, primarily U.S. Treasurys and the U.S. dollar, followed by the Swiss franc. This can cause funding currencies like the Japanese yen to appreciate rapidly, potentially wiping out carry trade gains.
• Leverage and rapid unwinding: Many carry trades are executed with high leverage in futures or forward currency markets. When market sentiment shifts, the rapid unwinding of these positions can lead to cascading losses.
• Reversal of the forward bias: Carry trades in forward markets rely on the phenomenon of forward bias, where currencies with higher interest rates tend to strengthen. However, this bias can reverse suddenly, leading to significant losses.
• Algorithmic trading impact: In foreign exchange markets, a great deal of panic selling can be generated by black box computer trading models (those whose owners may not fully understand their trading decisions), magnifying volatility when there’s panic in the market.

It’s worth noting that while individual risks might seem manageable, the real danger often lies when several of these occur at once. The sudden unwinding of carry trades during market shocks has contributed to several currency crises.

Example: The 2024 Japanese Carry Trade Unwinding

The yen carry trade, a popular strategy among investors, involves borrowing funds in Japanese yen—historically known for its low interest rates—and investing in higher-yielding assets such as U.S. Treasury or stocks. The 2024 market correction triggered by the unwinding of yen-related carry trades was not unprecedented.

A similar scenario unfolded during the 2008 financial crisis. By 2007, the Japanese yen carry trade had ballooned to an estimated $1 trillion, as investors capitalized on Japan’s near-zero interest rates to fund investments in higher-yielding assets globally. However, as the global economy lurched toward the abyss from 2007 to 2008, the widespread collapse in asset prices led to a rapid unwinding of these yen carry trades.

This unwinding caused significant currency fluctuations, with the yen appreciating sharply against typical carry trade target currencies like the U.S. dollar. The yen strengthened by as much as 29% against carry trade currencies in 2008, and the unwinding continued into 2009, with the yen appreciating 19% against the U.S. dollar.

In August 2024, global financial markets experienced significant volatility, with the S&P 500 index falling 3%—its largest single-day drop in almost two years. While many factors contributed to this decline, including disappointing economic data, the unwinding of the Japanese yen carry trade soon emerged as a key reason.

Under political pressure to counteract a rise in inflation, the Bank of Japan (BOJ) disrupted this strategy. The BOJ’s raised interest rates and reduced bond purchases, catching many investors off guard. As the yen strengthened against the U.S. dollar, investors were compelled to unwind their carry trade positions, leading to a surge in demand for yen and a sell-off in riskier assets.

The impact reverberated globally. Japan’s Nikkei 225 index plummeted 12% Aug. 5, 2024, marking its second-largest percentage decline on record. The S&P 500 also had significant losses, falling 3% the same day.

While the markets soon showed signs of stabilization, with both the S&P 500 and Nikkei 225 posting gains the following day, the future trajectory remained uncertain. Analysts at JP Morgan Chase (JPM) estimated that the unwinding of the carry trade was only 50 to 60% complete in August 2024, suggesting the potential for further market disruptions. By the end of that month, as we reported, U.S. Federal Reserve Chair Jerome Powell was promising a rate cut at the September meeting of the Federal Reserve Board.

What Is the Unwinding of Carry Trades?

The term “unwinding” in the context of the yen carry trade refers to the mass exodus of investors from this once-profitable strategy. Here’s what happens during this process:

1. Investors liquidate the assets they bought with borrowed yen, such as U.S. stocks or bonds.
2. They use the proceeds to repurchase yen, driving up demand for the Japanese currency.
3. Investors settle their yen-denominated debts, closing out their carry trade positions.

This unwinding easily creates a self-reinforcing cycle. As more investors unwind, the yen appreciates further against other currencies. This makes existing carry trades less profitable, prompting more investors to head for the exits. The assets initially bought with borrowed yen face selling pressure, which then trigger broader market declines. The ripple effects of this unwinding demonstrate the interconnectedness of global financial markets and how strategies built on small interest rate differentials can end up having anything but small effects in the broader economy.

Bottom Line

Carry trades are sophisticated investment strategies that exploit interest rate differentials between currencies. While potentially lucrative, they carry significant risks because of exchange rate fluctuations and the possibility of sudden market shifts. The 2024 yen carry trade unwinding demonstrates how changes in monetary policy, such as the Bank of Japan’s interest rate hike, can trigger widespread market disruptions.

This strategy’s effectiveness depends on accurate predictions of interest rate changes and currency shifts, making it primarily suitable for experienced traders with deep understanding of forex markets and risk management. Carry trades can lead to significant losses when market conditions change rapidly.