Removing crash risk from the carry trade

The carry trade borrows money from low interest rate currencies and invests in high interest rate currencies. On average, the carry trade is profitable, but is subject to significant crashes, which is why many investors think that the carry premium is a premium to take on this crash risk. But is it really?

Jonas Eriksen and Mads Kjaer from Aarhus University noticed something systematic in the carry trade. Higher yielding currencies tend to be currencies from countries with higher sovereign debt. That isn’t too surprising because one key driver of interest rates are obviously government debt levels.

Relationship between interest rates and government balance sheets

Source: Eriksen and Kjaer (2025)

Investors implementing a carry trade typically borrow from countries with net foreign asset and invest in currencies with higher net foreign debt positions. If the economy slows or we get into a financial crisis, the countries with more precarious debt positions will suffer more and the result is a carry trade crash.

But what if you invest in a carry trade within the group of net borrowers, i.e. countries with net foreign debt positions? In the chart below a traditional carry strategy would borrow from the low yielding currencies in portfolios P1 and P4 and invest in high yielding currencies in portfolios P3 and P5. A ‘debtor carry’ strategy, on the other hand would borrow from currencies in portfolio P1 and invest in currencies in portfolio P3. A ‘mismatch carry’ trade would borrow from currencies in portfolio P4 (net foreign lender and low interest rates) and invest in portfolio P3 (net foreign borrower and high interest rate).

Types of currency portfolios

Source: Eriksen and Kjaer (2025)

Note that the debtor carry strategy plays net foreign borrowers against each other so when a financial crisis hits of the global economy slows down, both currencies should be hit by similar crash drivers. Thus, the debtor carry strategy might be able to avoid crash risk. But does this come at lower returns?

The chart below shows the backtest performance of the classic carry trade, the debtor carry and the mismatch carry. As you can see, debtor carry strategies have the same long-term return as a standard carry strategy, but the ride is much smoother. Indeed, the crash risk of a standard carry trade or a mismatch carry trade can almost entirely be eliminated by following a debtor carry strategy.

Backtest of different carry trades

Source: Eriksen and Kjaer (2025)

This result is not only important for currency traders and hedge funds. It is also important for investors who hold international bond portfolios or multi-asset portfolios. I remember many instances from when I was managing multi-asset portfolio for private clients where we weren’t sure if we should buy Norwegian or Australian bonds. What if the currency crashes? This research allows you to think of a way out of this problem by financing investments in high yielding debtor countries by reducing low yielding debtor countries.