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Case Studies: Successful & Failed Carry Trades
"Explore real-world case studies of successful and failed carry trades. Learn what worked, what went wrong, and key lessons to improve your forex trading strategy."
Wikilix Team
Educational Content Team
The carry trade has generated as much interest in currency markets as any other trading strategy. It seems simple enough as a profit-making formula: Borrows (cheaply) in a low-interest currency, invest (more highly) in a higher-yielding currency and collect the difference.
Still, history has demonstrated that carry trades can produce incredible profits and catastrophic losses. By examining real-world examples where trading strategies partially relied on carry trades, we can better understand the full range of conditions that produce opportunities or counterproductive entries, making trades costly.
Before discussing the examples involving the carry trade, it is essential to recall the factors that drive a carry trade. These key factors are:
• Interest rate differentials between the funding and investment currencies.
• Market sentiment and appetite for risk that either assert themselves to hold positions, or lack the willingness to hold positions.
• Currency movements, which will either strengthen or wipe out the practical interest rate advantage.
In the future, let's examine real-life case studies of when traders made and lost fortunes.
The Yen Carry Trade, 1990s-early 2000s
For more than a decade, Japan sustained ultra-low interest rates to stimulate its sluggish economy. Consequently, yen became a classic funding currency. Traders borrowed (cheaply) in yen and purchased higher-yielding assets in most cases abroad, particularly US dollars, Australian dollars, and emerging market currencies. During periods of global stability, the trade worked out profitably.
The spread between interest rates was considerable, and the yen remained weak, giving traders both consistent carry income and occasional currency gains. Hedge funds, banks, and even retail investors got in on the action, making the yen carry trade one of the most popular global strategies of the day.
Lesson Learned: Low interest rates and stable markets can lead to a prolonged period of profitability. However, a dependence on only one funding currency means that if conditions change, the strategy can be vulnerable.
The Australian economy, buoyed by high commodity prices, often had interest rates much higher than those of other developed countries. The Australian dollar (AUD) has become a widely used target currency for individuals engaging in carry trades. There was intense market pressure to borrow in yen or Swiss francs and invest in AUD bonds or deposits that yielded exceptional returns over many years.
Traders were rewarded not just for the interest spread but also when the AUD increased in value due to demand for commodities such as iron ore and coal. In fact, for several years, the carry trade environment was one of the best offered in the early 2000s for traders.
Lesson Learned: Carry trades are always more successful when the interest rate differentials are consistent with strong economic fundamentals in support of the target currency.
Occasionally, currencies from Brazil, Turkey, or South Africa became attractive target currencies for carry trades due to their double-digit interest rates. These trades produced high returns when the risk-on appetite from global investors was present. For instance, stable cycles of being able to borrow at low-yield rates when trading the real, looking to make positive returns when trading the real, all while effectively selling and buying the costs up.
High yields can be rewarding, but only if political and economic stability persist for an extended period. The following examples illustrate unsuccessful carry trades.
The global financial crisis of 2008
The most notable collapse of carry trades occurred during the 2008 financial crisis. For many years, traders borrowed in yen and took on higher yields in investments in currencies such as the AUD and NZD, while also ignoring emerging markets. When panic started, many global investors rushed to unwind risky positions. The yen rose while other investment currencies fell as traders sought to repay their loans.
In a few weeks, billions of dollars were lost, and many positions that were considered safe for years suddenly spiralled out of control. Highly levered hedge funds suffered the worst.
Lesson Learned: Carry trades depend on stable, risk-on sentiment. When crises arise, unwinding can be quick, brutal, and swift.
In January 2015, the Swiss National Bank unexpectedly removed its peg to the euro currency. In one day, the Swiss franc gained nearly a 30% increase over the euro currency. Traders who had borrowed Swiss francs at low rates to invest in higher-yielding currencies suffered disastrous losses.
Many brokers and funds were caught off guard, and some smaller firms went out of business as a result. The Swiss Franc Shock became a textbook case of the impact market events can have on carry trades.
Lesson Learned: Never assume a central bank is going to maintain a policy forever. Unforeseen developments can undermine even the most calculated strategies.
On at least two occasions, Turkey's high interest rates drew capital from yield-hungry investors. However, political uncertainty, inflation, and concerns about the central bank's independence led to a rapid depreciation of the lira. Carry trades that initially appeared to be one-way bets ultimately proved disastrous and eventually led to currency losses that easily overwhelmed the accumulating interest income.
Lesson Learned: Political and economic risks must be evaluated alongside interest rate differentials; high yields are often high for a reason.
When comparing both case studies, specific themes emerged:
• Success typically happens when high interest rates happen to co-exist with a compelling fundamental story and stable markets.
• Failure generally occurs when central banks react to uncertainty or market volatility, or political instability destabilizes the currency in consideration for your investment.
• Leverage magnifies returns; a good trade that earns 3-5% a year may end up causing 50% losses if heavily levered.
The main takeaway is not to avoid going long a currency but to develop clarity in direction and strong risk management. Some guiding principles emerged based on history:
1. Don't fund and invest in a single currency pair - diversify.
2. Pay attention to central banks and to overall sentiment - the most significant risk is always policy surprises or crises.
3. Avoid excess leverage, so you can withstand sudden shocks without wiping out your capital.
4. Find supportive fundamentals in the investment currency - political stability, growth, and inflation that are manageable.
5. Always have an exit plan if the market reverses.
Carry trades can yield significant rewards, as indicated by the long stretch of profits from the yen carry trade and the Australian dollar boom. However, it can also lead to catastrophic losses, as demonstrated by the 2008 financial crisis, which affected multiple currencies, and the Swiss franc shock. Ultimately, who wins and loses depends on understanding that the rate differential is just one outcome. The market, central banks, and political events equally drive the outcome.
For traders, the challenge is to strike the appropriate balance between opportunity and caution, seizing favourable conditions while also protecting against unfavourable outcomes. Examining both successes and failures in the case studies better prepares investors and traders to know how to handle this strategy responsibly.
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14 min
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Intermediate
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