What if I told you there was a trade where you could earn 20-40% annually and had a high success rate. The only downside is that it occasionally collapses and completely wipes you out. Would you consider this trade? Welcome to the carry trade.
The carry trade is relatively straightforward--you purchase a high yield currency and short a low yielding currency. For example AUD/JPY. Australia has high interest rates compared to Japan. Currently Australia's interest rates are at 4.00% while in Japan is at 0.10% making for a 3.9% difference. Theoretically you could buy 100,000AUD/JPY and make an easy $3,900 or 3.9% annually. That is pretty good considering US interest rates are at 0-0.25%. Now what if I told you that if you use leverage say 10-1(forex dealers give away leverage like candy) you could earn $39,000 or 39% per annum. You are probably salivating at the opportunity right. The best part of this trade is that AUD/JPY does not even have to move up for you to make money (even though that would be nice). It could simply remain flat and you still get your 39%. This seems like free money doesn't it?
But what are the risks?
Because this is a leveraged position your greatest risk is that AUD/JPY could decline from say 83 to 74. When you are using 10-1 leverage you will lose your entire investment if AUD/JPY declines by 10% or more (unless you are willing to put up more margin). However carry trade supporters note that this only happens a few times a decade. On most days you will win and get to collect your interest. This is what makes the carry trade so desirable and dangerous. Statistically you will win but when the trade blows up, you expose yourself to huge tail risk.
The Yen can surge 10% very quickly during market crisis like the Asian financial crisis. In one famous week in October 1998 USD/JPY fell (yen surged) from 136 to 111. We also saw a dramatic rise in the yen in late 2008 with AUD/JPY falling from over 100 in July 2008 to 55 by December 2008. Anyone who was long the carry trade got destroyed.
Anyone contemplating the carry trade needs to be aware of the perils of such a strategy. Yes, you can make good money during normal market conditions but you always know in the back of your mind that it will eventually collapse (just ask Julian Robertson of Tiger management who lost $2 billion overnight). The only question is when and more importantly will you be able to get out. If you still think this is a great trade make sure you put on the trade during an economic expansion with low volatility. In my opinion the benefits do not outweigh the risk of 100% capital loss.
Black Swan Insights