The Carry Trade

“Foreign exchange carry trades tend to focus on situations where there’s a large differential between the interest rates of two countries and yet a high correlation between their currencies,” says Postnieks. “Some analyze these differentials on the basis of currency pairs, but a portfolio approach is more appropriate.”

According to Postnieks, most retail investors will consider the carry trade on the basis of a single-currency pair, since they don’t have access to models that are sophisticated enough to use covariance matrices capable of analyzing the developing relationships among numerous currencies simultaneously, i.e., as a basket. “Ninety percent of all retail investors lose money in futures markets, and I would be surprised if things are any different in the foreign exchange markets,” he says. “Retail investors don’t have the time or tools to manage risk on [a] long-term basis.”

Given all the complexities and risks and the growing number of participants, will the carry trade continue to yield profits for able traders in the future? Postnieks says the forward rate bias is one of the largest and longest-lasting anomalies in the financial markets. “Capital, in essence, gets trapped in low-interest, low-growth-rate, high-savings countries like Japan and Switzerland because of a natural home rate bias and the risk aversion of depositors in these countries,” he opines.

“This provides an opportunity for risk-adjusted, return-maximizing hedge funds to reallocate capital from where it is in surplus to where it is most needed–higher interest rate countries with generally higher gross domestic product growth rates,” Postniek concludes. “Viewed from this perspective, carry traders are performing a valuable function by allocating capital more efficiently than individual savers ever will.”