When will carry trades work best?

Carry trades generally are most profitable when investors as a whole have a very specific attitude toward risk.

Psychology drives the markets and people’s moods tend to change over time. Sometimes they may feel more daring and willing to take chances, other times they may be more timid and conservative. Investors, as a group, are no different. Sometimes they are willing to make relatively high risk investments, other times they are more fearful and seek safer assets. When investors as a whole are willing to assume risk, we say they have low risk aversion, or, in other words, they are comfortable taking risk. When investors are drawn to more conservative investments and are less willing to take on risk, we say they have high risk aversion.

Carry trades are most profitable when investors have low risk aversion, which makes sense when you consider what a carry trade involves. When buying a currency with a high interest rate, the investor is taking a risk — there is uncertainty about whether the country’s economy will continue to perform well and be able to pay high interest rates.

Countries with better growth prospects can afford to pay higher interest rates on the money that is invested in them, but there is always a chance something might change. Ultimately, investors must be willing to take this chance.

If investors as a whole were not willing to take on this risk, then capital would never move from one country to another, and the carry-trade opportunity would not exist.