How does the carry trade work, and why does it seem to violate uncovered interest rate parity?

The carry trade is one of the most discussed strategies in foreign exchange, and understanding why it works (and when it fails spectacularly) is essential for CFA Level II.

The Basic Strategy:

1. Borrow in a low-interest-rate currency (the funding currency)
2. Convert to a high-interest-rate currency (the target currency)
3. Invest at the higher rate
4. Earn the interest rate differential (the 'carry')

Example:

Avalanche FX Fund executes a JPY/AUD carry trade:

• Borrow JPY 1 billion at 0.5% for 1 year
• Convert to AUD at 0.0130 AUD/JPY (76.92 JPY/AUD)
• Receive AUD 13.0 million
• Invest in AUD deposits at 4.5%
• After 1 year: AUD 13.585 million

If the exchange rate is unchanged:

• Convert back: JPY 1,046.0 million
• Repay loan: JPY 1,005.0 million
• Profit: JPY 41.0 million (4.08% return)

What Uncovered Interest Rate Parity (UIP) Says:

UIP predicts that the high-rate currency should depreciate by the interest rate differential, eliminating the carry profit:

Expected AUD depreciation = 4.5% - 0.5% = 4.0%

So the AUD 'should' fall 4% against JPY, wiping out the carry.

Why UIP Fails (and Carry Works):

1. Forward premium puzzle — Empirically, high-rate currencies tend to depreciate less than UIP predicts, and sometimes appreciate. This is one of the most robust findings in international finance.
2. Risk premium — The carry return may be compensation for crash risk. Carry trades tend to unwind violently during global risk-off events.
3. Central bank behavior — Central banks may intervene to prevent rapid appreciation of their currency, supporting the carry.
4. Slow mean reversion — Even if UIP holds in the very long run, the adjustment takes years, leaving profitable windows.

The Risk — Carry Trade Crashes:

Carry trades exhibit a negative skew return profile. They earn small, consistent profits most of the time but suffer catastrophic losses when risk appetite collapses.

Exam tip: CFA Level II frequently tests whether a carry trade is profitable given spot rate changes. Calculate the total return (interest earned - interest paid +/- exchange rate change) and compare to what UIP would predict. Remember that carry trades are essentially short volatility positions — they profit in calm markets and lose in turbulent ones.

For more on FX strategies, check our CFA Level II economics section on AcadiFi.