Carry Trades When Risk Comes Off

A carry trade borrows in a low-yielding currency or asset and invests the proceeds in a higher-yielding one, harvesting the yield gap as long as exchange rates or prices don't move against the position. Most of the time this works quietly and profitably — small, steady gains, month after month, which is exactly what makes carry attractive and exactly what makes it dangerous.

The danger shows up when broad risk appetite falls. Carry trades are typically funded with leverage, and many traders run similar versions of the same trade at once, so when a shock hits and one participant needs to de-risk, they unwind by buying back the funding currency and selling the high-yield asset — pushing the exchange rate against everyone else running the same trade simultaneously. That forced selling triggers more stop-outs and margin calls elsewhere, and the unwind cascades quickly, producing sharp, correlated losses concentrated in the worst days for risk assets generally, rather than a gradual decline. This is often summarized as carry earning "steady income most of the time, with occasional sharp crashes" — a negatively skewed payoff profile.

The practical implication is that carry strategies should be sized and stress-tested against sudden, correlated unwinds, not against the smooth historical volatility observed during calm periods, since that history systematically understates the tail risk.