On FX Carry

Carry strategies are as old as the markets themselves, and almost everyone at some point has come up with the idea of "borrowing low and investing high".

Macro hedge funds love this idea too, mostly because of its ability to deliver solid market-neutral returns with low Beta and vol. The drawback comes with the tail risks, and the main skill in running this strategy lies in the ability to avoid and manage catastrophic events. More on that later.

💡The idea is simple:

- Borrow money in a low-interest rate currency
- Invest in a high-interest rate currency
- Profit from the interest rate differential
- Avoid periods of high volatility and regime changes

🌐Risk-neutral and risky worlds

In the risk-neutral "Q" world, expected future FX rates are equal to today's FX forward rates. Therefore, one is expected to earn a risk-free rate with no risk simply by means of the covered interest rate parity - buying FX spots and selling FX forwards.

However, we are not living in a risk-neutral world. By not covering the risk exposure, one enters the real world of risk and the "P" pricing. In this world, FX rates follow paths prescribed by trade balance, NIIP and other macroeconomic relationships.

FX risk is the reason why people are willing to flock into low-interest rate currencies (the risk buyers) and why others are willing to exploit the rate differential by engaging in the carry trades (the risk sellers).

💵 Taiwanese Dollar Example

For example, consider USD/TWD chart between May 2024 and May 2025. Quarterly deposits on USD were trading in range of 450-500 bp, while Taiwanese were lingering around 160-170 bp.

For Taiwanese investors (mostly life insurance companies), it was far too attractive to miss the opportunity to convert TWD into USD and invest in a high-yielding currency abroad rather than at home.

Red line (🟥) shows the term structure of USD/TWD FX forwards as of May 2024, predicting the currency path in a "risk-neutral" world (Q), where market risk is not priced in. In such a world, one would expect to buy USD at 32.474 and sell it one year later at 31.166, realizing an FX loss on USD, offset by its higher deposit rate.

However, that's not what happened in the "real world" (P). Thanks to the Taiwanese semiconductor industry and a positive trade balance with the US, the Taiwanese dollar enjoyed levels indicated by the blue line (🟦), above and beyond what was "deserved" by the interest rate differential.

Surplus on Taiwanese capital account was offset by deficit on investment account, thanks to all the lifers allocating capital to US Treasuries. This created tension in the investment position, which ultimately snapped in May 2025, resulting in a rapid unwinding of carry trades.

Another example is the JPY carry trade, which began in the early 1990s when the Bank of Japan slashed interest rates amid concerns over long-term economic growth. This strategy has remained popular ever since, though it occasionally backfires. Most recently, it made headlines in August 2024 when the Japanese yen experienced significant strengtening.

And that's the moral of today's story - those who are attracted by superior risk-adjusted returns on carry trades must be prepared for hidden fat-tail risks.