Other considerations

Posted by Scriptaty | 9:04 PM

While risk aversion is one of the most important things to consider before making a carry trade, it is not the only one. Here are some additional issues to take into account.

Low interest rate currency appreciation: Even if market participants are in risk-seeking mode, there are factors that can lead to a rally in the currency with the lower interest rate. When the low interest rate currency in a carry trade (the currency being sold) appreciates, it negatively affects the profitability of the carry trade.

For example, geopolitical risks or fears of terrorism tend to have a positive affect on the Swiss franc, which is widely considered the “safe-haven” currency.

In Japan, although interest rates are low, increased optimism about the Japanese economy has recently led to an increase in the Japanese stock market. Increased investor demand for Japanese stocks and currency has caused the yen to appreciate, and this yen appreciation negatively affects the profitability of carry trades such as the Australian dollar (high interest rate) vs. Japanese yen.

Trade balances: Trade balances (the difference between a country’s imports and exports) can also affect the profitability of a carry trade. When investors have low risk aversion, capital will typically flow from the low interest rate paying currency to the high interest rate paying currency.

However, this does not always happen. To understand why, consider that even though Japan currently pays historically low interest rates, there is strong demand for the Japanese yen. Although this can be attributed partially to the country’s recent recovery, a more important factor is Japan’s huge trade surplus. There is strong foreign demand for Japanese goods electronics, cars, etc. As a result, although the country offers low rates of return, Japan attracts trade flows into the yen. The point is that even when investors have low risk aversion, large trade imbalances can cause a low interest rate currency to appreciate.

Time-horizon: In general, a carry trade is a long-term strategy. Before entering into a carry trade, an investor should be willing to commit to a time horizon of at least six months. This commitment helps to make sure the trade will not be affected by the “noise” of shorter-term currency price movements.