Know When Carry Trades Work and When They Don't.

Do you know when carry trades work and when they don't？

Carry trades are most effective when investors are willing to take a risk and get hold of high-yielding currencies while selling lower-yielding currencies.

It's like to an optimist who sees the glass as half full. Despite the fact that the current scenario is not normal, he is optimistic that things will improve.

The same can be said of carry trade.

Even if economic conditions aren't ideal, the buying currency's perspective must be optimistic.

If a country's economy looks as fantastic as Angelina Jolie's or Brad Pitt's, the central bank will almost definitely have to hike interest rates to keep inflation under control.

Because a higher interest rate designate a larger interest rate differential, this is beneficial to the carry trade.

When Are Carry Trades Not Appropriate？

On the other hand, if a country's economic prospects aren't promising, no one will be willing to risk the currency.

Especially if the market believes the central bank will be forced to decrease interest rates in order to aid the economy.

Simply put, carry trades are most effective when investors have a low risk aversion.

When risk aversion is high, carry trades are ineffective (i.e. selling higher-yielding currencies and buying back lower-yielding currencies).

Investors are less willing to take risky enterprises when risk aversion is strong.

Let's put things in context.

Let's imagine the economy is struggling and the country is in the midst of a downturn. What do you think your next-door neighbor would do if he won a million dollars？

Your neighbor would most possibly choose a low-yielding but secure investment and invest it elsewhere. It makes no difference if the return is minimal as long as the investment is safe.

Finding yield is no longer a focus. It is about protecting the principle.

This makes sense because it gives your neighbor a backup plan in case things go wrong, such as if he loses his work.

Your neighbor is deemed to have a high level of risk aversion in forex lingo.

The mindset of major investors isn't all that dissimilar from that of your next-door neighbor.

When the economy is unclear, investors prefer to invest in safe haven currencies with low interest rates, such as the US dollar and the Japanese yen.

Check out WikiFX post on how risk aversion contributed to the unwinding of carry trades for a concrete example.

Carry trade is the polar opposite of this. As a result of this infusion of capital into secure assets, low-interest currencies appreciate against high-interest currencies.