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The Carry Trade: The Risk of Earning on Rate Differences

If you borrow money for almost free (around 0%) in Japan and put it into a U.S. bond paying 5% interest, wouldn't a 5% spread be left over even while you do nothing? This simple idea is exactly the carry trade—so let's look together at why on some days it collapsed the market in a single day.

What Is a Carry Trade?

A carry trade is a strategy of borrowing money in a cheap-interest currency and putting it into an expensive-interest currency or asset to earn that interest-rate difference (the carry).

The borrowing side is called the "funding currency." The Japanese yen (JPY) and the Swiss franc (CHF), which long had interest near 0%, were representative funding currencies.

The side you put the money into is called the "target currency." Higher-interest currencies like the Australian dollar (AUD) and New Zealand dollar (NZD), or assets like U.S. Treasuries, fall here.

For example, borrowing yen at 0.25% interest and putting it into a U.S. asset paying 5% interest makes the rate difference of about 4.75 percentage points, in theory, an "income that comes in while you do nothing."

Up to here it looks like a free lunch, but there's a trap hidden in the "exchange rate" we'll see below.

The "Puzzle" That Shouldn't Work in Theory but Works in Practice

Economics textbooks have a theory called "uncovered interest rate parity (UIP)." In theory, a high-rate currency should fall in value by that much, so that the gain from the rate difference is offset by the exchange-rate loss, and in the end there should be no free profit.

Yet actual data often show otherwise. High-rate currencies frequently show strength instead, so the carry trade has "on average" made money. Academics call this the "forward premium puzzle."

What matters starts here. Normally it earns a little steadily, but when a crisis comes, it loses a lot at once. Because it's shaped like climbing stairs quietly, then plunging by elevator, experts call this "crash risk."

Source: San Francisco Fed (SF Fed) Economic Letter, Gresham College. Why this excess return does not disappear is a "puzzle" that academia has not yet fully explained.

What Happens When Exchange Rates Flip: August 2024

The most vivid case is the "yen carry trade unwind" of the summer of 2024.

On July 31, 2024, the Bank of Japan (BOJ) raised its policy rate by 0.25 percentage points. It was a very small hike, but the direction itself was contrary to the market's expectations. The value of the yen, which had been borrowed cheaply, suddenly began to rise.

As the yen strengthened, those who had borrowed yen to invest found the cost of repaying their debt (yen) swelling in an instant. So a wave of "unwinding" rushed in as everyone rushed to sell their investment assets and buy back yen.

As a result, on August 5, 2024, Japan's Nikkei 225 index plunged about -12.4% in a single day. It was the worst single day since Black Monday in 1987, and on a point basis it was the largest decline in history. The impact didn't stop at Japan—on the same day the U.S. S&P 500 fell about -3% and the Nasdaq about -3.4%, and the fear index (VIX) spiked to 65. There are analyses that bitcoin and ethereum also plunged as much as around -20% at one point.

Cross-checked figures: CNN Business, Fox Business, BIS Bulletin No. 90 (2024). The total size of the unwound positions (e.g., a global short-yen peak of up to several trillion dollars) is an "estimate" with large variation by institution, so we do not assert it here.

The Illusion of a Quick Rebound — And the Lesson

Interestingly, the next day the Nikkei rebounded about +10%. On the surface, it's easy to be fooled into thinking "it recovered quickly."

But the problem is not the size of the fall—it's whether you were carrying "debt (leverage)" at that moment. Someone who borrowed money to invest can be forcibly liquidated (margin-called) during the -12% single-day stretch and lock in the loss without even getting to watch the rebound.

So the real risk of a carry trade explodes when three things overlap. First, when the exchange rate flips unfavorably. Second, when borrowed money (leverage) magnifies the loss several times over. Third, when everyone is crowded in the same direction, making the exit narrow.

'Returns of Almost Everything,' which built this harness, is a site that aims to show exactly these "hidden risks" without hiding them. For assets tangled with exchange rates, like the carry trade, the habit of checking the maximum drawdown, drawdown period, and FX effect together—rather than looking only at the rate-difference return—is important.

常见问题

Q. Do individuals do carry trades too?

It's mainly done at large scale by hedge funds and institutions, but individuals sometimes do it through foreign-exchange (FX) margin trading. However, most involve "leverage (borrowed money)," so even a slightly unfavorable exchange-rate move can make the principal vanish in an instant. Because it's a structure where you can suffer a "large loss" while aiming for a "small gain" from the rate difference, it's very dangerous for beginners.

Q. Then isn't it safe if you hedge the currency?

If you "hedge the currency" to remove exchange-rate risk, the cost generally runs about as much as the rate difference. That is, the moment you hedge, the rate-difference gain you were trying to earn from the carry trade tends to vanish along with it. This is a point that shows a method of "pocketing just the rate difference for free" is theoretically hard to establish.

Q. Is this an investment recommendation article?

No. This article is educational material for understanding the "principle and risks" of the carry trade as a strategy, and is by no means a solicitation to buy or sell a specific currency or asset. It also does not predict future exchange rates or prices. Checking the maximum drawdown and drawdown period first, for any strategy, is the principle of this site.