The Carry Trade: The Essentials of Theory, Strategy and Risk Management

Michael R Rosenberg

This chapter surveys the major theoretical issues and empirical evidence on the performance of FX carry trades. The chapter also discusses the strategic issues around the construction of a carry-trade portfolio, and what risk management tools and trading systems are available to manage the downside (tail) risks associated with FX carry trades.

The first section of the chapter discusses how a typical carry-trade cycle evolves over time – from an initial widening in interest rate spreads to a gradual build-up in net speculative positions in favour of high-yield currencies, and finally to the eventual forced unwinding of those positions when liquidity conditions tighten and risk appetite declines.

The second section examines the theoretical foundations of the carry trade. According to theory, the excess returns on FX carry trades should be zero if the uncovered interest rate parity (UIP) condition held. According to the UIP condition, high-yield currencies might offer an initial yield advantage over their low-yielding counterparts, but over time that yield advantage will tend to be offset by an expected depreciation of the high-yield currencies versus the low-yield currencies. The