rate fluctuations.
For a carry trade to work, the high-yielding currency must rise, or at the very least
remain steady, against the low-yielding one over a period of time.Adepreciation of
the high-yielding currency can cause carry traders to lose money, as they are betting
on an unchanged or a rising exchange rate of the currency pair, and this decline can
even erase any gains earned from the interest.
For example, if you go long on a currency pair like NZD/JPY as a carry trade, you
expect and want the New Zealand dollar to appreciate in value or at least remain
unchanged versus the Japanese yen for however long you intend to hold your
position for. If NZD/JPY goes up, you will stand to gain not just from the interest
spread, but also from capital appreciation. The risk then is for the carry trade pair
to decline more in percentage than what you would gain from the interest fees.
You must understand the fundamentals
If you are thinking of employing the Carry Trade Strategy, you must first
understand the fundamental factors that are supportive of carry trades, and be
confident that the high-yielding currency will continue to rise or stay unchanged
against the low-yielding currency over a period of time. Should market sentiment
reverse and change due to economic, monetary or political conditions, carry traders
may decide to liquidate their long positions (by selling), perceiving that the highyielding
currency would drop in value, and thus harm their long trades. This
unwinding can come about quickly and without much warning, and can usually last
for quite some time (months or even years) especially if overall perception towards
the currencies in the carry pair is changed drastically based on major fundamental
changes. Another reason for the possible prolonged unwinding of carry trades is
that not all carry trades will unwind at the same time.
NZD/JPY cross
For example, in 2005, the NZD/JPY cross was one of the more popular currency
pairs to carry trade as it offered a wide interest rate spread. At that time, with New
Zealand’s interest rates standing at 7.25% and Japan’s interest rates remaining at
0%, a trader buying the NZD/JPY could make 725 basis points from yield alone. If
a 10 times leverage had been applied to this carry trade, it would have yielded a
72.5% annual return from the rate gap alone, and that was in addition to capital
appreciation of the pair itself.
Anyway, NZD/JPY was in an overall uptrend in 2005, which was good news for
carry traders as they not only made on the substantial interest spread (if leveraged),
they also gained from the rising strength of NZD/JPY. However, near the end of
2005, things started to turn sour for carry traders. There were market rumblings
about the possibility of Japan discarding the Zero Interest Rate Policy, and
investors worldwide feared that the Japanese central bank was going to raise
interest rates sometime in 2006. That resulted in a six-month decline of NZD/JPY
as carry traders and investors closed their longs.
NZD/JPY was not the only currency pair to suffer the consequences of carry trade
unwinding. USD/JPY, being another hugely popular carry trade pair, also
experienced a severe and sharp decline from December 2005 till May 2006, when
the Bank of Japan hinted at raising interest rates in Japan.
Source: 7 Winning Strategies for Trading Forex: Real and Actionable Techniques for Profiting from the Currency Markets
