Carry Trade
Borrow low, lend high — and the volatility risk that owns the trade
- Define a carry trade and the simple math behind it
- Identify the conditions that make carry trades work
- Spot when a carry trade is about to unwind violently
Borrow yen at 0%, lend Mexican peso at 11%, pocket the 11% spread. Beautiful — until USD/JPY drops 8% in two days and your carry profit is gone for three years. Carry trades make money slowly and lose it fast. Understanding the mechanism is essential to FX.
The carry trade in one line
Borrow in a low-yield currency, lend in a high-yield currency, earn the differential (the 'carry'). Classic: borrow JPY at near-zero, buy MXN bonds at 11%. Each year you collect the spread. The trade works as long as the FX pair stays stable or moves in your favour.
Low volatility, range-bound FX, stable rate differentials, risk-on regime. The trade grinds positive returns daily. Investors pile in, pushing high-yielders even higher (positive feedback).
Volatility spikes, risk-off, safe-haven bid, sudden rate path shift in funding currency. The trade unwinds in days. Years of carry profit erased. Yen-funded EM carry trades the textbook collapse pattern.
Volatility is the silent killer
The math: a 10% annual carry sounds great. But if the FX pair drops 10% in one event, the year's carry is gone. If it drops 20%, you've lost 2 years' carry. High-carry currencies are typically more volatile — that's why they pay carry. The market is pricing the risk of unwind.
AUD/JPY carry trade has been profitable for 18 months. VIX suddenly spikes from 14 to 28. Best action?
- Carry = borrow low-yield, lend high-yield, earn the differential
- Works in low-vol, risk-on, stable regimes
- Vol spike = textbook carry unwind
- High yields exist because risk of unwind is real
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