Carry Trading

A carry trade earns money simply from holding a position, as long as prices stay roughly where they are. The classic example is borrowing in a currency with low interest rates and investing in a currency with high interest rates, pocketing the difference. The same idea exists in bonds, commodities, equities and crypto: any time an asset pays more to hold than it costs to finance, it offers positive carry. Carry strategies have produced positive average returns over long periods, but they are known for sudden, painful crashes.

What carry means#

Carry is the return you would earn on a position if prices did not change. It can come from:

How an FX carry trade works#

Why carry earns a return#

Economic theory, specifically uncovered interest rate parity, says high yielding currencies should depreciate by the rate differential, cancelling the carry. In practice, they often have not, on average, which is called the forward premium puzzle. Explanations include:

• Crash risk premium: carry traders are paid for accepting occasional large losses.
• Liquidity provision: carry investors provide funding that others need.
• Slow capital: not enough arbitrage capital to close the gap fully.

See Covered and Uncovered Interest Parity and Carry Factor.

The carry crash pattern#

Carry is often described as "picking up pennies in front of a steamroller". Returns tend to be steady most of the time and then fall sharply during market stress, when investors rush to close leveraged positions and funding currencies such as the yen rally.

• October 2008: as the financial crisis deepened, the yen surged against high yielding currencies such as the Australian dollar, and carry trades suffered heavy losses within weeks.
• August 2024: after the Bank of Japan raised rates and US data weakened, a rapid unwinding of yen funded positions coincided with a sharp jump in the yen and a sell off in global stocks.

This negative skew means carry returns have fat left tails. See Skewness and Kurtosis.

Managing carry trades#

1. Use modest leverage that can survive a sharp move against you. See Position Sizing.
2. Diversify across many carry pairs or markets rather than one big position.
3. Combine carry with trend or momentum filters, which can cut exposure when carry trades start to unwind. See Trend Following.
4. Watch volatility: carry tends to do worst when volatility spikes. Some traders reduce size when implied volatility rises. See Implied Volatility (IV).
5. Watch central bank policy: carry depends on rate differentials, which change with monetary policy. See Central Banks Explained.

Common mistakes#

• Focusing on yield and ignoring price risk.
• Using too much leverage because daily returns look smooth.
• Concentrating in one funding currency or one trade.
• Assuming past calm will continue. See Recency Bias.

Frequently asked questions#

What is a carry trade?#

A strategy that holds a higher yielding asset funded by a lower yielding one, earning the difference as long as prices stay stable.

Why are carry trades risky?#

Price moves can wipe out months of income quickly, and carry trades tend to suffer sharp losses together during market stress.

What is the yen carry trade?#

Borrowing in Japanese yen, which has had very low interest rates, to invest in higher yielding currencies or assets.

Next, learn how firms earn the bid ask spread in Market Making.