What Are the Risks of Carry Trades?
What Are the Risks of Carry Trades?
Carry trade risk encompasses multiple interconnected dangers that can erode or completely eliminate the accumulated interest gains that make carry trades attractive. While the interest rate differential may be steady and predictable, the exchange rates underlying the positions move unpredictably, and economic shocks can trigger sudden reversals. Leverage—commonly used to amplify returns—magnifies losses just as readily. Understanding these risks is not optional for traders considering a carry trade strategy; it is the foundation of whether a carry trade is viable at all.
Quick definition: Carry trade risk refers to the possibility that currency depreciation, interest rate changes, liquidity dry-ups, or leverage-induced margin calls will cause losses that exceed the interest income earned, resulting in a net loss on the position.
Key takeaways
- Currency depreciation is the largest risk: The funding currency may strengthen (the borrowed currency appreciates), erasing years of interest gains in weeks
- Leverage amplifies losses: Using 10:1 or 20:1 leverage means a 5% adverse currency move wipes out 50–100% of your capital
- Interest rate changes reduce or eliminate the differential: Central banks may cut rates in the higher-yielding currency or raise rates in the funding currency
- Liquidity dry-ups force immediate exits: During market stress, bid-ask spreads widen and you may be unable to close positions at reasonable prices
- Correlation risk: Multiple carry trade positions (across AUD/JPY, NZD/JPY, etc.) often move together, providing false diversification
- Systemic risk and tail events: Market shocks can trigger simultaneous unwinding across all carry traders, creating a stampede to exit
Currency depreciation risk
The most direct and consequential carry trade risk is currency depreciation—specifically, the appreciation of the funding currency (the currency borrowed). When you borrow in Japanese yen and invest in Australian dollars, you profit if the AUD strengthens and lose if the AUD weakens. A weakening AUD means you need more Australian dollars to buy back your yen borrowing.
Consider a real-world example: In 2007–2008, the AUD/JPY carry trade was extremely popular. Traders borrowed yen at 0.5% and invested in Australian dollars yielding 6.5%, pocketing a 6% differential. However, during the 2008 financial crisis, the AUD fell from 100 JPY per AUD to 60 JPY per AUD—a 40% depreciation. A trader with 1 million AUD in the carry position initially owed 100 million yen. At the crisis low, the position required 166.7 million yen to repay (1 million AUD ÷ 0.006 AUD/JPY). The currency loss of 66.7 million yen dwarfed six years of interest gains.
This risk is asymmetrical. Interest gains compound slowly over months and years. Currency losses can occur in days. A 1% annual interest differential becomes irrelevant if the funded currency falls 2% in a single week due to a central bank decision, a trade shock, or a geopolitical event.
Leverage-induced margin calls and forced liquidation
Leverage transforms a mild currency loss into a catastrophic hit to your capital base. If you use 10:1 leverage and control 10 million AUD with only 1 million AUD of capital, a 10% depreciation of the AUD against the yen wipes out your entire 1 million AUD capital. Most brokers enforce margin calls—forced closures of your position—when your account balance falls below maintenance requirements, typically 5–10% of the position size.
Suppose you deposit 500,000 AUD and use 10:1 leverage to open a 5 million AUD/JPY position. Your maintenance margin requirement is 250,000 AUD (5% of 5 million). If the AUD loses 5% against the yen, you lose 250,000 AUD. Your account balance drops to 250,000 AUD, hitting the maintenance margin exactly. Any additional losses trigger a margin call. The broker closes your position—often at the worst possible moment, when market liquidity is lowest and spreads are widest—crystallizing the loss.
The psychological and financial impact is severe. You intended to hold the position for 5 years to capture compound interest gains. Instead, you were liquidated in 2 months due to a temporary currency dip that would have recovered if you had sufficient margin buffer.
Interest rate risk and differential compression
The interest rate differential that justifies the carry trade is not fixed. Central banks change rates, and sometimes they change them dramatically. When the Reserve Bank of Australia raised rates from 0.1% to 4.35% between 2020 and 2022, the AUD/JPY differential widened, initially benefiting carry traders. However, if rates subsequently decline—as they might during a recession—the differential shrinks. A 6% differential can become 3%, reducing annual returns by half.
More dangerously, if the high-yielding currency's central bank cuts rates while the funding currency's bank raises rates, the differential reverses entirely. This happened with the Swiss franc carry trade in 2008. The CHF was borrowing at rising rates while the funded currencies fell in value and their yields declined. Traders exited en masse.
Additionally, changes in interest rates often signal broader economic problems. When the Reserve Bank of Australia cuts rates aggressively, it may be responding to a sharp economic downturn. That same downturn often triggers currency depreciation, compounding losses for carry traders.
Liquidity risk and market dislocations
Carry trades assume that you can exit positions when you choose. In normal market conditions, currency pairs like AUD/JPY are liquid, with tight bid-ask spreads (0.5–2 pips). However, during market stress, liquidity evaporates. Bid-ask spreads can widen to 10, 20, or even 50 pips, meaning you face a significant slippage cost when closing.
During the March 2020 COVID-19 market crash, the AUD/JPY spread widened dramatically as hedge funds and leveraged players simultaneously tried to exit carry positions. Many retail brokers were unable to fill orders at reasonable prices or temporarily suspended trading altogether. A trader trying to close a 5 million AUD position faced executions at a 20-pip spread instead of the typical 1-pip, translating to approximately 100,000 AUD of slippage—roughly 2% of the position value.
Worse, some brokers engaged in "requoting," refusing to execute orders at quoted prices, effectively locking traders into positions during the very moment they needed to escape.
Correlation risk and portfolio concentration
Many carry traders assume they are diversifying by holding multiple carry pairs: AUD/JPY, NZD/JPY, CAD/JPY, and others. In normal markets, these pairs move somewhat independently. However, during risk-off events (when investors flee risky assets for safe havens), all of these pairs often collapse simultaneously. The funding currency (JPY) strengthens against all of them at once, a phenomenon called "correlation convergence."
In August 2007, when credit concerns first emerged, AUD/JPY, NZD/JPY, and other carry pairs fell sharply in tandem. A trader holding four different carry pairs experienced a 50% drawdown across the entire portfolio in weeks, not the gradual bleed expected from idiosyncratic currency moves.
This concentration risk means that carry traders do not benefit from traditional portfolio diversification. The diversification is illusory.
Tail risk and sudden shocks
Carry traders are exposed to "tail risk"—rare, extreme market moves that occur outside the normal range of price variation. The 2008 financial crisis, the March 2020 pandemic shock, the September 2001 terrorist attacks, and the Brexit vote of 2016 are examples. These events trigger sudden, large currency moves that marginally leveraged carry traders cannot survive.
When Lehman Brothers collapsed in September 2008, the AUD/JPY pair fell from 100 to 60 in roughly four months—a move that was statistically "impossible" based on prior volatility measures, yet it happened. Traders holding leveraged positions were wiped out entirely, and many faced margin calls that required them to deposit additional capital immediately—capital they often did not have.
Correlation with other risks during crises
During crises, carry trade losses often combine with broker insolvency risk. If your broker fails (as happened with MF Global in 2011), your segregated account may still be frozen during bankruptcy proceedings, trapping your funds even if the broker's failure was not your fault.
Interest rate swap spreads and counterparty risk
When traders hold carry trades over extended periods, they often use interest rate swaps to hedge or adjust their funding costs. If the swap spread—the difference between swap rates and government bond rates—widens, your hedging costs increase unexpectedly. A 2% widening in swap spreads across the 5-year tenor means your financing costs rise by 2%, potentially eliminating the entire interest rate differential.
Additionally, you assume counterparty risk if you hedge through a bank. If that bank becomes insolvent or its credit rating drops sharply, you may struggle to roll or close your swap positions at reasonable prices.
Funding currency strengthening due to flight to quality
Paradoxically, the funding currency (yen, Swiss franc, dollar) often strengthens precisely when carry traders want to exit. Investors fleeing risk seek safe-haven currencies, and the funding currency is usually the safe haven. So when market stress rises—the exact moment carry traders want to exit—the funding currency appreciates most sharply, turning a "simple" exit into a devastating forced loss.
An example: In March 2020, the yen strengthened against every carry trade partner currency as equities collapsed and investors bought yen. Carry traders faced a double hit: margin calls due to leveraged losses, and the funding currency rallying against them, making it more expensive to close positions.
Decision Tree
Path dependency and duration of losses
A carry trade's profitability depends on the path taken, not just the ending exchange rate. Two trades with identical entry and exit prices may have very different outcomes. If one path experiences a sharp adverse move early (triggering a margin call), while another path experiences the same move late (allowing some interest accrual), the first suffers a forced loss while the second survives and profits.
This path dependency means that carry traders cannot rely on mean reversion. Even if the AUD/JPY "should" return to 100 in the long run, you must have sufficient capital and margin to survive the intermediate journey to 60 and back.
Summary
Carry trade risk is multifaceted and often underestimated. Currency depreciation, leverage-amplified losses, interest rate changes, liquidity dry-ups, and correlation breakdowns can all combine to create devastating outcomes. Tail events and sudden market shocks can wipe out years of accumulated interest gains in days. The safety of a 4% interest differential is illusory if you face a 10–20% currency loss. Successful carry traders manage these risks through careful leverage discipline, diversification across uncorrelated assets (not just different currency pairs), stop-loss orders, and crisis monitoring.