Because carry trades are least profitable when investors are highly risk averse, traders who already have carry trades must stay abreast of the risk environment and prepare for when it changes.
Investors’ willingness to make risky trades can change dramatically from one moment to the next. Often such large shifts are caused by significant global events. When investor risk aversion does rise quickly, the result is generally a large capital inflow into low-interest rate, “safe-haven” currencies.
Such conditions can set the stage for carry trades to lose money.
For example, in the summer of 1998 the Japanese yen appreciated against the dollar by more than 20 percent in two months, mainly because of the Russian debt crisis and the LTCM hedge-fund bailout. Similarly, just after the Sept. 11, 2001, terrorist attacks, the Swiss franc rose by more than 7 percent against the dollar over a 10-day period.
The leveraged carry trade strategy is still very popular in the currency markets. By properly assessing the risk environment, traders can increase the probability of successfully executing the carry trade strategy.
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