In the universe of investment strategies employed across global financial markets, few are as widely practiced — and as frequently misunderstood — as the carry trade. For investors navigating the complexities of emerging markets, and Latin American assets in particular, a thorough grasp of the carry trade is not merely academic. It is a practical necessity. Interest rate differentials that define the region’s monetary landscape, combined with chronic currency volatility and episodic capital flow reversals, make the carry trade one of the most consequential forces shaping asset prices, exchange rates, and sovereign borrowing costs across the hemisphere.
What Is the Carry Trade?
At its most fundamental level, the carry trade is a strategy in which an investor borrows capital in a low-interest-rate currency — the “funding currency” — and deploys those proceeds in a higher-yielding asset denominated in a different currency — the “target currency.” The investor’s profit, or “carry,” is the net interest rate differential between the two positions, after accounting for any exchange rate movements over the holding period.
The concept is elegantly simple in theory. If an investor can borrow in Japanese yen at 0.1% per annum and invest in Brazilian reais at 13.75% per annum, the gross carry exceeds 13 percentage points before exchange rate effects. The critical qualifier — “before exchange rate effects” — is where the strategy’s complexity, and its risk, is concentrated.
The Uncovered Interest Rate Parity Puzzle
Standard economic theory, through the principle of Uncovered Interest Rate Parity (UIP), predicts that the carry trade should generate zero expected profit in equilibrium. According to UIP, the high-yielding currency should depreciate by exactly the amount of the interest rate differential, leaving the carry trader no better off than if they had simply stayed in the funding currency. In practice, however, UIP is one of the most consistently violated predictions in international finance. High-yielding currencies tend to depreciate less than UIP predicts — and often appreciate — at least over short to medium horizons. This empirical regularity, sometimes called the “forward premium puzzle,” is what sustains the carry trade as a viable strategy in professional investment practice.
The persistence of carry trade profitability is linked to the fact that currency markets do not operate in a frictionless, risk-neutral environment. Risk-averse investors require compensation for holding currencies exposed to sudden, severe depreciations. The carry premium thus partially reflects a genuine risk premium for bearing crash risk rather than pure arbitrage. Understanding this distinction is central to responsible carry trade management.
The Latin American Context: An Exceptionally Fertile Environment
Latin America presents some of the most pronounced interest rate differentials in the world, driven by structural factors including chronically elevated inflation, fiscal imbalances, shallow domestic capital markets, and high country risk premia. This makes the region simultaneously one of the most attractive and one of the most perilous environments for carry trade strategies.
Brazil: The Benchmark High-Yield Carry Target
Brazil occupies a unique position in the global carry trade landscape. The Selic rate — Brazil’s benchmark overnight rate set by the Banco Central do Brasil — has historically been among the highest of any major economy, regularly exceeding 10% in real terms during tightening cycles. With the Selic at 13.75% in 2023 and subsequent adjustments thereafter, Brazil has consistently attracted substantial carry inflows from investors funded in dollars, euros, or yen.
The Brazilian real (BRL) has accordingly experienced carry-driven appreciation during periods of global risk appetite, only to suffer sharp, rapid devaluations when global conditions deteriorate and carry positions are unwound. The 2018 emerging market selloff, the 2020 pandemic shock, and various episodes of fiscal uncertainty illustrate how quickly carry flows can reverse, translating theoretical interest rate advantages into actual capital losses for investors who do not actively manage their currency exposure.
Mexico: Banxico and the Dollar Proximity Effect
Mexico’s carry dynamics are substantially shaped by its deep financial integration with the United States. The peso (MXN) is the most liquid emerging market currency in the world by trading volume, which reduces transaction costs and bid-ask spreads, making it a preferred vehicle for institutional carry strategies. Banco de México (Banxico) has maintained significant positive spreads over the Federal Reserve’s benchmark rate, particularly during the 2022-2024 tightening cycle, which generated persistent carry inflows and contributed to unusual peso strength despite elevated global uncertainty.
The proximity to the United States creates a dual dynamic: on one hand, strong trade linkages and nearshoring trends provide structural support to the peso; on the other, any deterioration in U.S.-Mexico trade relations or a sharp Fed pivot toward easing can compress spreads and trigger rapid carry unwinds.
Colombia and the Andean Region
Colombia’s peso (COP) and the Banco de la República’s aggressive rate hike cycle in 2022-2023 — which took the policy rate to above 13% — briefly made Colombia one of the highest-yielding carry destinations in the region. However, Colombia illustrates an important principle: a high nominal rate alone does not make a currency an attractive carry target if underlying fundamentals — fiscal trajectory, current account deficit, political uncertainty — create persistent depreciation pressure that exceeds the interest differential.
Argentina: The Extreme Case
Argentina represents the cautionary extreme. Nominal interest rates have at various points exceeded 100% per annum, yet the carry trade in Argentine pesos has been structurally unviable for most international investors due to capital controls, multiple exchange rate regimes, and hyperinflationary episodes that systematically destroy the real value of peso-denominated assets. Argentina underscores a critical lesson: high nominal yields are not synonymous with attractive carry opportunities. The carry trade requires not only a high interest differential but also a degree of currency predictability and capital account openness that Argentina has frequently lacked.
Mechanics of Execution: How Professional Investors Implement Carry
In practice, carry trades in emerging market currencies are implemented through several instruments, each with distinct risk and liquidity profiles.
Non-Deliverable Forwards (NDFs)
For currencies subject to capital controls or with limited onshore convertibility — such as the Brazilian real in some configurations, or the Colombian peso — non-deliverable forwards (NDFs) are the standard vehicle. An NDF is a cash-settled forward contract that allows investors to gain exposure to the interest rate differential without actually holding physical currency onshore. Settlement is in U.S. dollars, based on the difference between the contracted forward rate and the spot rate at maturity.
Currency Swaps and Cross-Currency Basis
Sophisticated institutional investors also access carry through cross-currency swaps, exchanging floating-rate obligations in a funding currency (typically USD SOFR) for fixed or floating payments in the target currency. The cross-currency basis — the spread embedded in these swap arrangements — can itself be a source of carry return or an additional cost, depending on market conditions and the direction of global dollar demand.
Local Currency Government Bonds
A more direct and commonly used approach involves purchasing local currency sovereign bonds — Brazilian NTN-Bs and LTNs, Mexican Mbonos, Colombian TES — which provide both the carry yield and the duration premium of the local rate curve, while exposing the investor to both currency and interest rate risk. These instruments are accessible to foreign investors through the Euroclear system and local custodians.
Risk Dimensions: What Can Destroy a Carry Position
The carry trade is often described as “picking up nickels in front of a steamroller.” Returns accrue slowly and predictably when conditions are favorable, but losses can materialize suddenly, violently, and in sizes that dwarf accumulated carry income. Understanding the specific risk vectors is essential.
Exchange Rate Risk and Sudden Stops
The primary risk in any carry trade is an adverse exchange rate movement that exceeds the interest differential. In emerging markets, this risk is amplified by the phenomenon of “sudden stops” — episodes in which global capital abruptly reverses direction, as foreign investors simultaneously unwind carry positions, triggering a self-reinforcing depreciation spiral. Sudden stops are typically catalyzed by external shocks: a sharp rise in U.S. Treasury yields, a deterioration in global risk appetite (measured by indices such as the VIX), or idiosyncratic country-level crises.
The 2013 “Taper Tantrum,” triggered by the Federal Reserve’s signal of tapering its quantitative easing program, produced simultaneous depreciations across nearly all major emerging market currencies within weeks, erasing months of accumulated carry income. Latin American currencies were among the hardest hit, with the Brazilian real and South African rand leading the selloff.
Volatility and Crash Risk
Carry trade returns exhibit a distinctive statistical profile: positive returns with relatively low volatility in tranquil periods, punctuated by severe negative returns (negative skewness and excess kurtosis) during stress episodes. This “crash risk” profile means that standard risk metrics — particularly Value at Risk (VaR) calculated under normality assumptions — significantly underestimate the true tail risk of carry positions. Investors must apply stress testing and scenario analysis frameworks that explicitly model sudden stop and risk-off episodes.
Liquidity Risk
During risk-off episodes, bid-ask spreads in emerging market currency markets widen dramatically, and market depth deteriorates. An investor holding a substantial BRL or MXN carry position may find that exiting the trade quickly requires accepting prices substantially worse than mid-market quotes, adding transaction costs on top of mark-to-market losses at precisely the worst moment.
Political and Institutional Risk
Carry trades in Latin America are uniquely exposed to political risk. Policy shifts — an unexpected change in central bank leadership, fiscal expansion that raises sovereign risk, or the imposition of capital controls — can abruptly alter both the interest rate differential and the currency’s trajectory. Argentina’s repeated imposition of capital controls exemplifies how political decisions can strand carry positions, preventing investors from repatriating capital even when they wish to exit.
The Interaction Between Carry Flows and Monetary Policy
Central banks in Latin America are acutely aware of carry flows and their influence on domestic monetary conditions. Large carry inflows generate currency appreciation pressure, which — while beneficial for controlling import-driven inflation — can harm export competitiveness and create financial stability risks if a sudden reversal occurs. This creates a policy dilemma: maintaining the high rates that attract carry flows may overshoot domestic monetary tightening requirements, while cutting rates to reduce carry attractiveness risks inflationary pass-through from currency depreciation.
Brazil’s Banco Central has historically been one of the more sophisticated central banks in managing this tension, using macroprudential tools, reserve accumulation, and FX swap operations to smooth carry-driven volatility without fully surrendering monetary policy independence. The effectiveness of these tools varies considerably across the region — smaller economies with shallower FX markets have fewer instruments available and are correspondingly more vulnerable to carry-driven volatility.
Portfolio Construction Considerations for Emerging Market Carry
For a portfolio manager allocating to LatAm assets, the carry trade should be approached not as a standalone strategy but as an integrated component of a broader framework that accounts for correlation structures, risk budgeting, and macro regime analysis.
Diversification Across Carry Targets
Concentrating carry exposure in a single high-yielding currency amplifies idiosyncratic risk. A diversified basket approach — allocating across BRL, MXN, COP, and Peruvian sol (PEN) — reduces the impact of country-specific shocks while preserving the regional carry premium. However, investors must be aware that during global risk-off episodes, correlations between EM currencies typically spike toward one, reducing the diversification benefit precisely when it is most needed.
Carry-to-Volatility Ratios
Rather than chasing the highest nominal yield, sophisticated carry investors focus on the carry-to-volatility ratio (analogous to a Sharpe ratio for carry strategies). A currency offering 8% carry with 6% annualized volatility represents a more attractive risk-adjusted opportunity than one offering 15% carry with 25% volatility. Implied volatility from FX options markets provides a market-based estimate of prospective currency risk.
Macro Regime Conditioning
Carry strategies perform best in low-volatility, risk-on macro regimes. Conditioning carry exposure on macro indicators — global risk appetite measures, U.S. dollar momentum, commodity price trends — can substantially improve the risk-adjusted return profile. Reducing carry exposure during periods of elevated VIX or USD strengthening trends is a well-documented approach to mitigating crash risk.
Hedging Costs and Carry Erosion
Investors who hedge their currency exposure via FX forwards effectively eliminate the carry — since the forward rate is determined by the interest rate differential. Partial hedging strategies, or dynamic hedging triggered by volatility thresholds, represent a middle path between unhedged carry exposure and fully hedged (zero-carry) positions.
Conclusion: The Carry Trade as a Lens on Emerging Market Dynamics
The carry trade is more than an investment strategy. It is a prism through which the macroeconomic structure of emerging markets — their inflation dynamics, fiscal positions, monetary policy credibility, and integration with global capital markets — is continuously being priced and repriced by international investors. For investors focused on Latin America, understanding carry mechanics is inseparable from understanding the forces that drive exchange rates, sovereign spreads, and local interest rate curves.
The strategy’s appeal is enduring precisely because Latin America’s structural features — persistent inflation differentials, institutional frameworks under development, and integration into global capital markets — sustain the interest rate differentials that generate carry. But its risks are equally enduring. The history of the region is punctuated by episodes of rapid, painful carry unwinds that have inflicted severe losses on investors who treated the strategy as passive income rather than as active risk-taking.
The disciplined carry investor in Latin American markets must therefore combine rigorous macro analysis, careful position sizing, dynamic risk management, and a clear-eyed understanding of the political economy of each target country. When these conditions are met, the carry trade remains one of the most powerful tools for generating risk-adjusted returns in the emerging market asset class. When they are not, the steamroller arrives — and rarely gives warning.
This article is intended for informational and educational purposes only. It does not constitute investment advice or a recommendation to buy or sell any security or financial instrument. Investing in emerging market assets involves significant risks, including currency risk, political risk, and liquidity risk. Investors should consult qualified financial advisors before making investment decisions.
