Carry trades exposed to significant exchange rate volatility

A Banque de France analysis highlights how currency carry trades, while seeking to profit from interest rate differentials, are heavily exposed to exchange rate volatility. Recent market instability since 2024 has underscored the critical impact of currency fluctuations on these strategies.

The carry trade's currency gamble

Carry trade operations exploit interest rate differentials by borrowing in low-yield currencies to invest in higher-yield currencies.

However, the associated exchange rate risk can entirely negate gains from these differentials.

The study details a common strategy in 2024: borrowing in Japanese yen to invest in Mexican pesos, leveraging a nearly ten-percentage-point yield differential.

This strategy initially outperformed the US equity market until early June 2024, when the Mexican presidential election results triggered a sharp depreciation of the peso.

This depreciation accelerated in July 2024 following an unexpected interest rate hike by the Bank of Japan, making the strategy unprofitable by summer 2024. Conversely, from mid-2025, the peso's recovery against the yen amplified the interest rate differential, rendering the strategy profitable again.

This illustrates how exchange rate volatility significantly impacts carry trade outcomes, often overshadowing the more stable evolution of interest rate differentials.

Beyond rate differentials: The carry-vol ratio

The expected return of a carry trade position does not solely depend on interest rate differentials.

Exchange rate risk can completely alter performance, either absorbing or amplifying anticipated gains.

The paper argues that comparing carry-vol ratios – which relate interest rate differentials to exchange rate volatility – offers more relevant investment opportunities than considering only rate differentials.

Once this volatility risk is accounted for, optimal carry trade strategies are not limited to emerging market currencies, which are often more volatile, but can include G10 currency pairs.

For instance, since January 2024, financing in Swiss francs (CHF) to invest in US dollars (USD) proved more advantageous than financing in USD to invest in Mexican pesos (MXN), despite the wider rate differential in the latter case.

This shift reflects how market volatility modifies classic positioning, pushing investors to seek better risk-adjusted returns.

A fragile strategy in turbulent times

The analysis underscores the inherent fragility of carry trade strategies in periods of heightened market volatility.

Relying solely on interest rate differentials without accounting for currency fluctuations is a perilous approach, as demonstrated by the Mexican peso and Japanese yen example.

While offering potentially high returns, these positions carry significant risks that can quickly erode gains, demanding a more nuanced risk assessment from investors.