Forex "Carry Trading" Risks

Forex "Carry Trading" Risks

Submitted by adil on Mon, 01/27/2014 - 11:11

Carry Trade Forex strategy has garnered real importance in recent years. However, the carry trade also fosters a lot of risks these days due to recent currency market changes and accompanying volatilities. Most of the traders are also of the opinion that carry trade will never regain the same viability again. The future of carry trade is still uncertain and depends heavily on stability in currency markets and global economic conditions.

The Working of Carry Trade:

You should understand the working of carry trade before understanding why it is no longer working. In carry trade, a trader tries to earn profit from the increasing or decreasing currency pair value as well as the difference in interest rates between the two countries.

In carry trading, the trader will go short or sell the currency with low interest rate and goes long or buys the currency with higher interest rate. What a trader is doing here that he is trying to capture any increase in the currency as well in addition to take profits from interest rate differentials. Sometimes the carry traders prefer profits earned through positive interests rather than the trade itself.

For instance, a trader sells Japanese Yens and buys New Zealand dollars simultaneously paying .30% and earning 6.5% respectively. As a result, the trade earns 6.15% that is equal to interest rate difference if the currency pair maintains the same rate throughout the year. Therefore, with 100k position, the trader can actually earn 6150 NZD because he has earned 6.15% interest on 100,000 and as a result, the leverage is 10:1 where trader can put up 10k.

This particular currency pair has been especially popular among carry traders recently as they buy it for great trading opportunity not because of growing New Zealand economy.  The eyes of currency traders actually lit up when the Reserve Bank of New Zealand offered 8 percent interest rate in addition with paying a cost of 0.5% for Japanese yen both at the same time.

Resultantly, traders earned massive profits as the value of New Zealand dollar was increasing as compared to Japanese Yen and the interest rate differentials between countries were also high. Similarly, 7.5% interest rate on margined funds proved to be icing on the cake.

Why Carry Trade is declining:                                              

There are many factors that have contributed to the downfall of this seemingly long lasting strategy. Some of these factors are as under.

• Increased Risk Aversion:

Traders in recent times have decided to close carry trades position as the market became more volatile and they became extra fearful of risk assets. Carry trade did offer short term benefits to the traders but as most of the beneficial carry trade currency pairs are riskier, it is most suitable for calm and less volatile markets resulting in the closure of carry trade positions.

• Government Intervention:

Governments usually intervene in Forex market when the currency pair increases or decreases in value more than expectations of Central Banks but it happens very rarely. The lack of Government intervention caused favorite carry trades currency pairs such as NSD/JPY decline and major traders suffer heavy losses as new generation of traders occupied the market. The central banks did not even hint about any such action and as a result, carry trade suffered a heavy blow.

• Decreased Interest Rates:

Many global markets have decreased interest rates as they are unstable and desperate to reach free markets. This strategy has compelled traders to reconsider their carry trade positions most of which were long term. The interest rate differentials in important currency pairs are too low now and traders are suffering heavy losses instead of earning profits.