When Offshore Carry Trade Fail

Carry trade is the most popular strategy in the foreign currency exchange market for the past decade. This involves buying currencies yielding high interest and selling currencies that yields low interest rates.

It is important to choose the best pair of currency as this could mean gaining or losing. Usually, high yield currencies are New Zealand and Australian dollars. And the low yield currencies would mostly be the Japanese Yen (U.S. dollar can be used but it’s high volatility does not make it the best candidate). Profit will be gained out of this strategy by its ability to earn interest. Investors on long carry trades get profit counted daily, except on Wednesdays where a triple rollover is necessary to cover Saturday and Sunday rolls. For those who are fading their currencies (short carry trades), interest is paid daily.

Forex market trading is a long-term strategy that suits investors more than traders, because investors will be too happy in checking on the international market rates about twice or thrice a week than several times a day. The very foundation of the this specific game is to get paid while you wait, so waiting is actually a good thing.

When does it fail?

1. Central Bank Reduces Interest Rates. When there’s a significant drop in the interest rate of your high yield currency, as in the case of the country’s economic crisis, the gain stops and losses will be apparent. That is why it is important to choose a pair of currencies that either appreciate, or stays the same. Further on, traders will look elsewhere to put on their money as it is risky to invest in a declining currency, leading to lesser demand for the currency pair and eventually, a sell off. In this instance, leverage that could bring exponential gains can also bring exponential losses.

2. Central Bank Interferes with Forex. Foreign currency trading will also fail should central bank mediate and stop its currency from appreciating or to negotiate to prevent its currency to drop further. Now, you might be wondering in what cases would Central Bank hinder a rise in its currency. That’s because for export dependent countries, a very strong currency would hurt the export industry. For example, if the New Zealand dollar gets too strong, its Central Bank would have to suppress the currency’s growth, and thus affect the profit that traders and investors are after.

Knowing that what could fill your pocket could also bite you, means that you have to establish a delicate balance between risking and safeguarding your wealth. To most big time investors, this means neutralizing the risks by multiple investments. In their “basket” would be three highest and three lowest yielding currencies. That way, one currency pair’s loss could still be covered by the other two investments. The downside of course, would be the fact that this will involve enormous amounts of money. But then again, for multi-million dollar, risk-taking investors, it’s truly best to be safe than sorry.