Currency-funded carry trades fuel global credit, linking cheap money to real investment, risk and economic cycles.
Nov 17, 2025
Alessandro Mazzarini
For years, the currency carry trade has quietly shaped global financial flows. First documented by the Bank for International Settlements in its 2007 quarterly review (just before the global financial crisis) the phenomenon re-entered the mainstream debate after the shock that hit Japanese equities in August 2024.
This article offers a clear and readable guide. We begin with the basic mechanics of the carry trade, trace its evolution and key players over the past two decades, and finally examine the uncertainties and systemic vulnerabilities this strategy can create for financial systems and the real economy.
The core question is simple only in appearance: how do we resolve the inherent duality of the carry trade? Is it primarily a speculative strategy, or a channel through which systemic fragilities spread? To answer, we start from the foundations.
The Mechanism
The logic of the carry trade is simple; its consequences are not. At its core lies a basic rule: borrow in a low-yielding currency (typically the Japanese yen, the Swiss franc, or cyclically the US dollar) and invest the proceeds in higher-yielding foreign assets. Quantitatively, the expected return is the combination of the interest-rate differential and the evolution of the exchange rate.
A practical example: suppose an investor borrows yen at 0.5% and reinvests in 10-year US Treasuries yielding 4%. The nominal spread is 3.5%, the “mechanical” benefit of the carry. But the exchange rate is the crucial risk. If the funding currency appreciates, or the target currency weakens, the nominal gain can evaporate quickly. Behind an apparently safe yield lies an unavoidable second component, currency uncertainty, capable of turning profits into losses.
What Drives The Carry Trade? A focus on the Yen
To understand both returns and risks, the yen remains the most instructive case study.
Over the past twenty years, Japan’s economic and political trajectory has been shaped by the long aftermath of the 1990s asset bubble and the so-called “lost decade.” This context pushed the Bank of Japan toward an exceptionally accommodative stance: zero or negative rates combined with broad stimulus measures, turning the yen into a structurally “cheap” funding currency for global carry trades.
Two indicators summarize the dynamics:
Divergent policy rates: while the Fed Funds Rate has followed the cyclical rhythm of the US economy, the BoJ’s policy rate has hovered near zero for years, reinforcing the yen’s role as a funding currency (chart 1).
Implied volatility in the USD/JPY exchange rate: derived from option prices, it reflects market expectations and perceived FX risk. In this case, it has shown a tendency toward stability.
Two metrics have become particularly useful:
Carry-to-risk ratio—the interest-rate spread divided by implied FX volatility; it measures expected return per unit of risk.
Risk reversal—the price difference between call and put options on the same currency pair. A wide positive risk reversal signals that the market demands a higher premium to hedge against appreciation of the target currency. In the USD/JPY case, it reflects a sentiment broadly favorable to the carry trade.
On the macro level, central banks anchor the interest-rate spread. Yet the most unpredictable component is exchange-rate expectations, which incorporate not only anticipated policy moves, but also the real economy: trade dynamics, productivity, and political risk.
In other words, what fuels the proliferation of the carry trade is not the spread itself, but the shared expectation that relative prices will remain stable. It is this promise of stability that enables arbitrage beyond the scope of the theoretical Uncovered Interest Rate Parity (UIP).
August 2024's "Black Monday": The Other Side of The Coin
The events of August 5, 2024 exposed the structural fragility of the carry trade. Confronted with inflation readings that were firmer than anticipated, the BoJ announced a first, modest rate hike of 15 basis points and signaled a gradual path toward normalization.
Markets reacted swiftly and violently: the Nikkei fell by roughly 13%, with spillovers to the S&P 500 and Stoxx Europe, as many investors unwound speculative yen-related positions.
Estimates from the BIS and major investment banks suggested that the shift in rate expectations triggered the unwind of 50–60% of speculative positions, out of a pre-shock exposure of roughly ¥40 trillion (≈ USD 250 billion). The BoJ’s crisis management—targeted communication, commitment to gradualism, and clear signals of support—helped contain the turbulence.
The lesson, however, was clear: once expectations shift, the combination of leverage and currency exposure can amplify movements dramatically. Even if well-calibrated communication can soften the blow, highly open economies face an unavoidable constraint: cross-border financial channels can limit the autonomy of domestic monetary policy.
From Speculative Positions to Trade Credit: Spillovers Into The Real Economy
Recent research has shown that the carry trade is no longer confined to speculative finance. It increasingly functions as a funding channel for firms and commercial credit.
Studies by the BIS (including work by Bryan Hardy, Felipe Saffie, and Ina Simonovska) highlight that foreign-currency borrowing often finances day-to-day operations, particularly trade credit, rather than purely high-yield investments.
A central finding, based on thousands of emerging-market firms, is that each dollar of FX debt tends to generate a substantial amount of new current assets (around 35%) used to sustain operating liquidity and commercial payments. In this sense, the carry trade becomes a genuine credit channel: FX loans support production chains and help firms maintain payment continuity.
The vulnerability emerges when the funding currency appreciates abruptly. Hedge funds can close speculative positions quickly; non-financial firms cannot. They remain exposed to currency mismatches that affect balance sheets directly. The resulting stress may trigger cost restructuring, delayed payments, wage compression, and even supply-chain disruptions, typically beginning upstream and hitting suppliers first.
The "Shadow Channel" of Global Credit
Tracking and quantifying these transmission mechanisms is extremely difficult. The structures that blur the line between financial markets and corporate balance sheets create what can be described as a shadow channel of global credit. Three elements make it especially problematic:
Offshore vehicles: a significant portion of issuance and lending flows through offshore SPVs (i.e. Special Purpose Vehicle) in lightly regulated jurisdictions. These structures obscure the true allocation of risk across corporate groups.
OTC derivatives and FX swaps: much synthetic funding occurs through swaps, forwards, and options. Since these instruments do not always generate immediate cash flows, they may not appear as net debt in standard balance sheets, masking leverage and FX exposure.
Rise of NBFIs: investment funds, asset managers, and other Non-Bank Financial Institutions now play a major role in funding and derivatives markets. Unlike banks, they are not subject to Basel-style capital and liquidity requirements, complicating supervision and increasing cross-border risks.
Together, these forces make it difficult to determine who is exposed to what and under which conditions. Traditional balance-sheet analysis and official statistics risk underestimating the true degree of vulnerability.
Conclusions
The carry trade embodies a clear duality. On one hand, it allocates capital more efficiently by channeling resources from surplus to deficit agents. On the other, it can transmit systemic fragilities that materialize abruptly when expectations about rates or exchange rates shift.
The question, then, is regulatory and political: how should policymakers respond?
A coherent approach requires:
improved data collection and integration,
greater transparency on exposures—especially OTC derivatives and off-balance-sheet activities,
and a regulatory framework adapted to the growing importance of NBFIs.
Only with these tools can monetary, fiscal, and industrial authorities make informed decisions without being blindsided by hidden exposures.
Looking forward, macroeconomic monitoring will likely depend on three priorities:
(i) strengthening statistical and supervisory capacity;
(ii) updating rules to account for non-bank funding and offshore vehicles;
(iii) promoting risk-management tools for firms so that international credit does not become a vector of systemic contagion.
A broader question remains: will regulation drive the reduction of vulnerabilities, or will the market itself eliminate the least resilient practices? The answer will likely lie in a combination of both smarter regulation and adaptive markets. But one premise is unavoidable: without better information and updated rules, the carry trade will continue oscillating between a source of efficiency and a potential trigger of systemic fragility.