How the carry trade becomes a trap: understanding the financial bicycle

The mechanism behind the strategy

The financial bicycle, known in English as carry trade, represents one of the tactics most employed by global financial institutions to generate returns. Its operation is deceptively simple: financing is obtained at a low interest rate in one currency and that capital is reassigned to assets or instruments that generate higher rates in another currency.

Let's take a practical example. A fund manager requests financing in Japanese yen at a rate close to 0%, converts those funds into US dollars, and invests them in US Treasury bonds that pay 5.5% annually. The difference between the two rates — that 5.5% — constitutes the profit, as long as the exchange rates remain stable.

Why large institutions embrace this strategy

Hedge funds, investment banks, and large wealth managers often resort to financial engineering because it provides a relatively predictable income stream without relying on the appreciation of the underlying investment. It is especially attractive during periods of calm in the markets when investors have a higher risk tolerance.

The use of leverage intensifies the appeal of these trades. By borrowing multiples of their available capital, participants amplify their potential gains. This same tool also magnifies losses when things go awry.

History of Disasters: When the Financial Bicycle Goes Off the Rails

The yen-dollar strategy worked for decades like a money-making machine. International investors borrowed cheaply in yen to invest in higher-yielding U.S. assets. Everything changed on July 4, 2024, when the Bank of Japan surprised the markets with an unexpected increase in its interest rates. The value of the yen surged sharply.

That movement triggered massive panic. Thousands of carry trade positions were simultaneously forced into liquidation. Investors, besieged by growing losses on their yen loans, were forced to sell risk assets to recapitalize. The consequences spread globally: a drop in emerging market stocks, extreme volatility in currencies, and instability that nearly replicated the effects of the 2008 crisis.

Anatomy of Exchange Rate Risk

The greatest inherent danger of the carry trade is exchange rate risk. If the currency in which the loan was taken suddenly appreciates against the currency in which the investment was made, the investor faces considerable losses when repatriating funds.

Let's imagine the scenario: you borrow in JPY to buy USD. If the yen strengthens against the dollar, you need more dollars to obtain the yen necessary to repay the loan. The profit from the interest rate differential evaporates and generally turns into a loss.

Exposure to changes in monetary policy

Central bank decisions create unpredictable earthquakes. If the central bank that issued the borrowed currency raises interest rates, the cost of financing increases and margins are cut. At the same time, if the central bank of the investment currency cuts rates, the available yields decrease.

Both scenarios erode the profitability of the carry trade. In 2024, Japan was the epicenter: the shift in Japanese monetary policy not only raised rates but also coincided with an appreciation of the yen that amplified the losses of those holding leveraged positions.

Market Volatility: The Catalyst for Collapse

Financial cycling operations thrive during stable and bullish markets. When economic uncertainty emerges, the dynamics change radically.

In volatile contexts, investors abandon speculative strategies to seek refuge in safe assets. Carry trade positions are massively liquidated, generating cascading sales. Risk instruments crumble, interest rate differentials invert, and negative feedback accelerates. A leveraged market amplifies every movement, transforming healthy corrections into systemic crises.

Conclusion: sophisticated tool for experts

The financial bicycle remains a legitimate strategy, but only for those who possess deep expertise in global markets, currency dynamics, and sophisticated risk management. Experienced institutions can weather the turbulence; novice players face potential ruin.

The reality is that the carry trade concentrates an uncomfortable truth: seemingly “risk-free” returns always carry hidden risks. When those risks materialize —as happened in July 2024— the impact spreads to entire global markets.