Few investment strategies generate as much debate — and as many asymmetric outcomes — as the carry trade. For investors operating in or around Latin America, where interest rate differentials are among the widest in the world and currency dynamics are perpetually in flux, understanding the mechanics, risks, and practical applications of the carry trade is not optional. It is foundational.
This article examines the carry trade from first principles, explores how it manifests across the Latin American landscape, and provides a framework for evaluating whether — and how — LatAm-focused investors should incorporate it into a diversified portfolio.
What Is the Carry Trade?
At its core, the carry trade involves borrowing in a low-interest-rate currency and investing the proceeds in a higher-yielding currency or asset. The investor “carries” the position and earns the interest rate differential — the carry — as long as the exchange rate does not move adversely enough to eliminate the spread.
The strategy is deceptively simple. If the U.S. federal funds rate stands at 4.5% and Brazil’s SELIC rate is at 13.75%, a trader who borrows in USD and deploys capital into Brazilian reais-denominated instruments theoretically captures a spread of over 900 basis points. The catch, as history repeatedly demonstrates, is that exchange rate volatility can unwind those gains in a matter of hours.
The carry trade is not unique to Latin America — it has been a cornerstone of global FX strategy for decades. But LatAm’s combination of structurally high domestic rates, commodity-linked currencies, and idiosyncratic political risk creates both exceptional opportunities and exceptional hazards.
The LatAm Interest Rate Landscape
Brazil: The Dominant Carry Market
Brazil commands the most liquid and institutionally developed fixed-income market in Latin America, and its SELIC rate has been one of the highest among G20 economies for much of the past decade. The SELIC has oscillated between 2% (its historic low during 2020-2021) and 13.75% during the post-pandemic tightening cycle, creating dramatic swings in the carry calculus for international investors.
For investors, Brazil offers several carry vehicles beyond simple cash deposits. The NTN-B (Tesouro IPCA+) — inflation-linked government bonds — provides a real interest rate component that has frequently exceeded 5-6% above IPCA inflation, an extraordinary yield by global standards. The DI futures market allows sophisticated investors to express carry views with leverage and without taking direct foreign exchange spot exposure, though hedging the BRL remains an integral cost consideration.
The BRL/USD has historically been one of the most volatile major currency pairs. During the 2002 Lula electoral uncertainty, the 2008 financial crisis, the 2015-2016 Dilma impeachment saga, and the March 2020 COVID shock, the real depreciated sharply, destroying carry returns for unhedged positions. The lesson is not that carry fails in Brazil — it is that timing and hedging structure matter enormously.
Mexico: The USD-Proximate Carry Play
Mexico occupies a unique position in the LatAm carry universe. Its deep financial integration with the United States — USMCA, remittance flows, near-shoring investment — has historically made the Mexican peso more responsive to global risk appetite and U.S. monetary policy than its LatAm peers. Banxico has maintained real positive rates for most of the past decade, and the MXN has at times been termed the “carry currency of choice” for institutional funds seeking EM exposure with relative liquidity.
What makes Mexico instructive is the correlation dynamic. When global risk appetite is healthy and U.S. growth is solid, the MXN tends to appreciate or hold steady, enhancing carry returns. When U.S. recession fears spike or global risk-off sentiment accelerates — as in 2020 or during Fed tightening shocks — MXN depreciates sharply. Mexico’s carry trade is thus, in many respects, a leveraged bet on global risk sentiment dressed up as a yield play.
Colombia and Chile: Smaller Markets, Structural Dynamics
Colombia’s central bank (Banrep) has demonstrated willingness to maintain real positive rates, though the COP has faced persistent pressure from oil price volatility and political uncertainty. Chile, as a small open economy heavily tied to copper prices, offers carry opportunities that are fundamentally intertwined with commodity cycle positioning. An investor going long the CLP for carry is implicitly taking a view on Chinese construction demand and global copper inventories.
These smaller markets are less liquid, spreads are wider, and hedging costs are higher — factors that structurally reduce the net carry available to foreign institutional investors.
The Mechanics of Carry: What Determines the Return
The total return of a carry position can be decomposed into three components:
- Interest Rate Differential (the “carry”): The nominal spread between the funding rate and the investment rate. This is the gross carry — the number that gets quoted in strategy reports.
- Exchange Rate Movement (the “roll”): The appreciation or depreciation of the target currency against the funding currency. This is the variable that makes or breaks carry strategies. Uncovered interest rate parity (UIP) theory predicts that high-yielding currencies should depreciate to offset the carry — in practice, UIP fails persistently in the short to medium term, which is why carry works. But when it reverts, it reverts violently.
- Hedging Cost: If an investor uses forward contracts or cross-currency swaps to hedge FX exposure, the cost roughly equals the interest rate differential (by covered interest rate parity). This eliminates the FX risk but also most of the carry — which is why truly profitable carry trades involve accepting at least partial currency risk.
The “Carry Crash”: When the Trade Unwinds
The academic literature — and hard market experience — documents a phenomenon known as the carry crash. Carry trades tend to produce slow, steady positive returns in benign conditions, punctuated by rapid, severe drawdowns during periods of market stress. The return distribution is characterized by negative skewness and excess kurtosis — small, frequent gains and rare, large losses.
For Latin American currencies specifically, the triggers of carry crashes have included:
- Global risk-off events: COVID-19 (March 2020), Lehman Brothers (2008), Taper Tantrum (2013) — all produced simultaneous BRL, MXN, and COP depreciations of 15-30% within weeks.
- Domestic political shocks: Brazilian election uncertainty, Colombian fiscal reform failures, Argentine peso crises — idiosyncratic events that can hit one currency while others remain stable.
- Commodity price collapses: Particularly impactful for Brazil, Colombia, and Chile where fiscal accounts and current account balances are sensitive to oil and copper prices.
- U.S. dollar strength cycles: When the DXY enters a sustained appreciation cycle — often driven by Fed divergence from global peers — the dollar strengthens broadly, compressing or eliminating carry returns across EM.
The 2022-2023 Fed tightening cycle provides a recent case study. As the Fed raised rates from 0.25% to 5.5%, the USD/BRL rose from approximately 5.20 to 5.90 at points, even as Brazilian nominal rates rose in parallel. An unhedged carry position funded in USD would have seen currency losses partially or fully offset the nominal spread during certain periods.
Practical Instruments for LatAm Carry Implementation
Government Bond Markets
The most direct carry implementation involves purchasing local-currency sovereign bonds. Brazil’s Tesouro Direto for retail investors and the secondary market for NTN-B and LTN bonds provide liquid access. Mexico’s MBONOS and CETES are similarly accessible. These instruments deliver the interest rate differential directly, with FX exposure unhedged.
For international investors, access is typically through emerging market bond funds, ETFs, or direct market access for institutional accounts. Key products include the iShares JPMorgan EM Local Government Bond ETF (LEMB) and the VanEck EM Local Currency Bond ETF (EMLC), both of which carry significant BRL and MXN weights.
FX Forward and NDF Markets
Non-deliverable forwards (NDFs) allow investors to express currency views and earn carry without physically holding local currency deposits. The BRL NDF market is particularly deep and is widely used by hedge funds and macro traders. NDFs settle in USD, eliminating local market access requirements but introducing counterparty risk.
High-Yield Corporate Bonds
LatAm corporate bonds — particularly in Brazil, Mexico, and Chile — often trade at spreads above U.S. comparables that incorporate both sovereign risk and genuine credit risk. For investors willing to accept both currency and credit exposure, local-currency corporate bonds can offer carries of 15-20%+ in nominal terms. The risk-adjusted merits require careful analysis of individual issuer fundamentals and currency outlook.
Structured Products and Dual-Currency Notes
Sophisticated investors sometimes access carry through structured products that embed FX optionality into fixed-income instruments. Dual-currency notes, for example, pay an enhanced coupon in exchange for the investor accepting settlement in a weaker currency if exchange rates move adversely. These products concentrate the negative skewness of carry into explicit contractual terms — understanding the embedded option value is critical before investment.
Risk Management: A Framework for LatAm Carry Positions
Given the asymmetric return profile, risk management is the central discipline in carry trading. Several frameworks have proven effective:
Position Sizing by Volatility Budget
Rather than allocating a fixed nominal percentage to carry positions, experienced practitioners size positions relative to a pre-defined volatility budget. If BRL/USD realized volatility is 12% and a portfolio has a 2% annual volatility budget for this position, the appropriate allocation is determined by the volatility constraint — not by the attractiveness of the yield differential alone.
Carry-to-Risk Ratios
A simple but powerful heuristic: before entering a carry trade, calculate the ratio of annualized carry to annualized currency volatility. A BRL position with 9% carry and 14% FX volatility produces a carry-to-risk ratio of 0.64 — meaning the currency must move less than 0.64 standard deviations against you in a year for the trade to break even. Historical data suggests LatAm currencies frequently experience 1-2 standard deviation annual moves, underscoring the importance of disciplined entry points.
Valuation Anchors
Carry positions entered when the target currency is near or above fundamental fair value (estimated through purchasing power parity, current account modeling, or macroeconomic frameworks) have historically outperformed those entered during periods of extreme currency appreciation. Entering BRL carry when the real is already historically strong against the dollar increases drawdown risk; entering when the real is cheap reduces it.
Portfolio-Level Correlation Management
LatAm currencies are highly correlated during risk-off episodes — BRL, MXN, COP, and CLP often depreciate simultaneously. Building a “diversified” carry portfolio across multiple LatAm currencies does not provide the risk reduction that true diversification implies. Investors must recognize that LatAm multi-currency carry is, in stress scenarios, essentially a single factor bet on global risk appetite.
The Macroeconomic Context: 2025-2026
The current environment presents a nuanced carry backdrop for LatAm investors. Brazil’s SELIC has moved through a tightening cycle driven by fiscal concerns and inflation re-acceleration, maintaining the BRL’s status as a high-carry currency. Mexico’s Banxico has begun a gradual easing cycle from peak rates, compressing the MXN carry somewhat but leaving it still positive against USD and EUR. Argentina’s financial normalization — following years of multiple exchange rate regimes — is creating new, albeit high-risk, carry dynamics as peso rates stabilize.
The key macro variables to monitor over the coming 12-18 months:
- Fed trajectory: Any resumption of Fed rate cuts reduces the USD funding cost and widens the carry differential, while a higher-for-longer stance compresses it.
- China growth: Commodity-linked currencies (BRL, CLP, COP) are sensitive to Chinese industrial demand data. A hard landing in China would pressure these currencies regardless of domestic carry dynamics.
- Brazilian fiscal trajectory: The primary fiscal balance and debt trajectory are the central drivers of BRL fair value. Deteriorating fiscal dynamics have historically been the primary trigger for BRL underperformance relative to the carry differential.
- U.S. political risk and tariff dynamics: Trade policy uncertainty — particularly regarding USMCA — creates episodic volatility in the MXN that can rapidly unwind carry positions for Mexico-focused investors.
The Investor Verdict: Is LatAm Carry Worth It?
The evidence, taken in aggregate, suggests that the LatAm carry trade rewards disciplined investors who understand its risk profile and manage it accordingly. Several conclusions are well-supported:
Carry works, but not passively. Static buy-and-hold carry positions tend to underperform relative to dynamically managed strategies that reduce exposure during global risk-off regimes and increase it during stable, risk-on environments. The Sharpe ratio of passive EM carry significantly improves when risk filters — based on VIX levels, credit spreads, or momentum indicators — are applied.
Hedging costs matter. For investors who want carry exposure with currency protection, the fully-hedged yield is typically close to the risk-free rate — meaning investors are paying a high insurance premium for limited net return. Most successful carry investors accept partial currency risk and manage it actively rather than hedging it fully away.
Size is the decisive variable. Small, well-timed carry positions in a diversified portfolio meaningfully enhance risk-adjusted returns. Large, concentrated positions introduce drawdown risk that can destabilize overall portfolio performance. The maximum allocation to unhedged LatAm currency carry for a conservative institutional portfolio is typically cited at 5-10% of total assets; for aggressive mandates, perhaps 15-20%.
Institutional access matters. Retail investors in Latin America accessing carry through mutual funds, ETFs, or structured products typically receive inferior net yields compared to institutional investors with direct market access — fees, currency conversion spreads, and structural inefficiencies compound over time.
Conclusion
The carry trade in Latin America is neither a free lunch nor a fool’s errand. It is a systematic exposure to the premium that high-inflation, high-political-risk economies must offer investors to attract capital. That premium is real, persistent, and substantial — but it comes packaged with the asymmetric return profile that defines all carry strategies: steady gains interrupted by sudden, severe drawdowns.
For LatAm investors — whether managing personal savings, running institutional mandates, or advising clients — the relevant question is not whether to engage with carry dynamics, but how. Understanding the mechanics, sizing positions appropriately, monitoring the macro environment that drives currency fair value, and maintaining the discipline to reduce exposure when global conditions deteriorate: these are the competencies that separate investors who extract value from the carry premium from those who become victims of the carry crash.
The interest rate differentials are real. The rewards are real. So are the risks. Invest accordingly.
This article is for informational and educational purposes only. Nothing herein constitutes investment advice or a recommendation to buy or sell any financial instrument. Investors should consult qualified financial advisors before making investment decisions.
