Carry Trade and Currency Hedging

Carry Trade Strategies and Currency Hedging in EM

Carry trade is one of the main strategies in EM local currency debt, based on obtaining a positive spread between the yield of an investment and the cost of funding. For a CIO, understanding the mathematics of carry and approaches to hedging currency risk is critically important.

Mathematics of Carry Trade

The basic formula for carry trade return:

Total Return = Yield Pickup + FX Return + Roll-Down Return

Where:

Yield Pickup = Yield of EM bond - Cost of funding (USD rate) FX Return = Change in EM currency rate vs USD Roll-Down Return = Income from movement along the curve with constant shape

Example of Carry Trade Calculation (Brazil)

Key Insight: With full currency hedging, carry almost disappears (covered interest rate parity). Carry trade only works when accepting currency risk.

Covered Interest Rate Parity (CIP)

Theoretically, the forward rate is determined by:

$ F/S = \frac{1 + r_{domestic}}{1 + r_{foreign}} $

Where:

• $F$ — forward rate
• $S$ — spot rate
• $r_{domestic}$ — rate in domestic currency (EM)
• $r_{foreign}$ — rate in foreign currency (USD)

This means: high EM yield is offset by expected devaluation in forward points.

Uncovered Interest Rate Parity (UIP) — Why Carry Works

Empirically, UIP is systematically violated — this is called the Forward Premium Puzzle:

• High-yielding currencies DO NOT depreciate as quickly as the forward predicts

Carry trade historically generates positive alpha

But: periodic sharp losses (crash risk) — fat tails

Historical Results of Carry Trade

Currency Hedge Cost by Country

Currency Hedging Strategies

Roll-Down Strategy in EM

Roll-down return — income from bond movement along the yield curve with constant shape:

$ \text{Roll-Down Return} \approx \text{Duration} \times (\text{Yield at purchase} - \text{Yield at shorter maturity}) $

Example for Brazil (steep curve):

Insight: Roll-down works with a steep and stable curve. During inversion periods — it yields a loss.

Practical Framework for Choosing Hedge Ratio

• Assess carry pickup: If carry < 2% after hedging — no point in hedging
• Assess currency volatility: Vol > 15% = consider hedge
• FX direction conviction: Strong view = less hedge
• Liquidity of hedge instruments: NDF markets are less liquid
• Investment horizon: Short term = less reason to hedge (costs > benefit)
• Correlation with portfolio: If EM FX correlates with other risks — hedge

Signals for Changing Hedge Ratio

Hedging Instruments

Risks of Carry Trade: Crash Risk

Carry trade is characterized by an asymmetric return distribution:

• Many small positive returns (carry accrual)
• Rare but large losses (currency crashes)
• Negative skewness, excess kurtosis

Historical Examples of Crash Risk:

CIO Recommendations for Carry Trade

• Sizing: Limit EM local currency to 20-30% of fixed income allocation
• Diversification: Minimum 5-7 currencies in portfolio
• Stop-loss: Set drawdown limits (e.g., -10% per country)
• Rebalancing: Regular rebalancing for profit capture
• Crisis hedging: Have tail hedge (put options) for extreme events
• Monitoring: Weekly analysis of FX momentum and positioning