Carry trade
What is Carry trade?
A currency carry trade borrows or sells a lower-yielding currency to invest in a higher-yielding currency, seeking to earn an interest differential.
Backtests must include contemporaneous forward rates, funding, spreads, roll, collateral, leverage, and crash periods. Ranking currencies by today's interest rates across historical dates is look-ahead bias. Returns should be decomposed into interest differential, spot movement, volatility management, and transaction cost.
Position sizing should reflect negative skew, crowding, liquidity, and correlated deleveraging rather than recent volatility alone.
Governance should cap aggregate exposure across funds and derivatives that may express the same hidden funding trade.
Basic structure
The investor funds in one currency and holds an asset or deposit in another, or implements the exposure through forwards and derivatives. Return combines interest differential, spot currency movement, forward pricing, financing, and cost. A positive yield gap does not guarantee profit because exchange-rate loss can exceed the accumulated carry.
Forward implementation
Currency forwards embed relative interest rates, so carry can be represented by buying currencies at forward discounts and selling those at premiums under a defined convention. Actual return depends on roll dates, collateral, spreads, and basis. Forward premium is not a pure forecast, and textbook parity can differ from executable institutional pricing.
Why returns may exist
Proposed explanations include compensation for crash and liquidity risk, behavioral extrapolation, slow adjustment, segmentation, and policy regimes. Carry can earn steadily during calm periods and lose abruptly when risk aversion rises or funding currencies strengthen. The return distribution can be negatively skewed and crowded across managers.
Portfolio role and risks
Carry may diversify some portfolios but can share risk with credit, equities, volatility selling, and leveraged strategies. Funding stress, gaps, controls, counterparty exposure, and margin calls can force exit. Currency interest rates also reflect inflation and sovereign conditions, so high nominal yield is not necessarily high real reward.
Practical analysis
Define universe, signal, rebalance, leverage, volatility scaling, funding, forward source, costs, and crisis controls. Attribute spot and carry separately and test devaluations, correlation shifts, illiquidity, and delayed execution. Use point-in-time rates and tradable instruments. Do not infer future return by ranking today's yields or annualizing a brief calm period.
Sources and further reading
- Currency Management: An Introduction, CFA Institute
- Triennial Central Bank Survey of foreign exchange and Over-the-counter Derivatives Markets, Bank for International Settlements