How a Falling Dollar Hurts the Carry Trade

The dollar has fallen of late but the damage is not so much to those holding greenbacks as those engaging in the carry trade. Here is how a falling dollar hurts the carry trade. Bloomberg describes this as the biggest risk from the dollar drop.

A high-risk corner of the $5.1 trillion-a-day currency market has become the collateral damage of the dollar selloff.

Whipsawed by the greenback and confronted by U.S. policy confusion, carry trades were supposed to be a rare bright spot for investors who want to stay away from the world’s biggest reserve currency. Under the strategy, you borrow in low-rate alternatives such as the yen, and buy high-yielding peers like the Mexican peso, benefiting from low volatility and the emerging-market rally.

Practitioners of the carry trade are learning there’s no hiding from the dollar’s influence. Growing doubts about the outlook for U.S. policy following the failed attempt at health-care reform not only led to a weaker dollar, it also caused investors to pile into havens such as the yen and the euro — the funding currencies carry traders sell as part of the strategy. The Japanese currency gained 2.2 percent against the dollar this month, while the euro rose 2.7 percent.

When uncertainty roils the currency market money moves into safe haven currencies. Unfortunately safe haven currencies like the yen and Swiss franc have very low interest rates. Thus there is the temptation to sell francs and yen and buy currencies where interest rates are higher. Depending on the precise circumstances the most popular carry trade varies from year to year. Most recently Taiwan ranked high in this regard.

How Much Leeway Do Carry Traders Have?

Today you can get 7% on a Mexican bond. Japanese bonds pay around zero percent, occasionally in the negative. So you have an 7% per year margin in the carry trade. But, if you trade with a lot of leverage that changes things. Investopedia discusses the currency carry trade.

As for the mechanics, a trader stands to make a profit of the difference in the interest rates of the two countries as long as the exchange rate between the currencies does not change. Many professional traders use this trade because the gains can become very large when leverage is taken into consideration. If the trader in our example uses a common leverage factor of 10:1, he can stand to make a profit of 10 times the interest rate difference.

The big risk in a carry trade is the uncertainty of exchange rates. Using the example above, if the U.S. dollar were to fall in value relative to the Japanese yen, the trader runs the risk of losing money. Also, these transactions are generally done with a lot of leverage, so a small movement in exchange rates can result in huge losses unless the position is hedged appropriately.

Last September it took 5.0475 pesos to buy one yen and today it takes 5.5866.That is just over a 10% difference. If you had engaged in a carry trade with no leverage buying Mexican pesos with yen starting in September you would have lost 10% as the yen has climbed and regained half a year of interest or 3.5% on your Mexican bonds. If you had a standard tenfold leverage on your trade things would be a lot worse and you probably would have had to deal with margin calls along the way on your trading account.