Are There Any Risks With A Carry Trade?

by : Joel Teo

A carry trade can be a great way for a Forex investor to reap terrific profits on their investment. A carry trade is when a currency with a low interest rate is sold to purchase a currency that pays a high interest rate. The difference in the interest rate between the two currencies is called the interest rate differential. One of the biggest advantages of a carry trade can be the chance for a high return, but that does not mean that there are no risks with a carry trade, because there are.

The biggest risk in a carry trade strategy is the absolute uncertainty of the exchange rates. Because of this, it is important to look at more than just the interest rates on the currencies before you trade on the Forex market. Looking at the directional bias of the pairs that you are considering is a good way to determine if trading in those pairs is a smart move for you. If the carry trade pair declines more in percentage than the gain in the interest rate, you can still lose money in capital while gaining in interest. This can cause an overall loss even though you are making money on the interest rate differential.

With a carry trade, there are two objectives. The first is obviously to make money on the interest rate differential. The second objective is to gain a profit from the capital appreciation. If the carry trade pair appreciates in value, it is a better return on the initial investment. There is a risk involved by not meeting one objective or the other, or both. The risk of losing money with a carry trade is a definite one, but smart investors use Forex trading strategies to minimize these risks.

A big risk with carry trades is that interest rates will vary, and these variations can cause a carry trade that was an excellent return opportunity to turn sour and become a bad investment which loses money instead of gaining it. Carry trades are meant to be long term investments, and the currency can depreciate as well as appreciate. This creates a risk for Forex traders who can lose money when this happens. No foreign currency is completely stable, and fluctuations in the foreign currency exchange create risks for Forex traders when dealing with carry trades. Forex traders should do their homework and know the risks. They should also never risk more than they can afford to lose on the market.

Copyright © 2007 Joel Teo. All rights reserved.