Iceland currency crisis highlights risks of carry trades

One of the most popular types of investments among forex traders is the so-called ‘carry trade,’ in which investors borrow one currency that charges a low interest rate and purchase a different currency that offers a high interest rate. The goal is to profit from the interest rate differential (the gains from lending minus the cost of borrowing). In times of loose monetary policy and simultaneous forex stability, carry traders can extract enormous profits. However, as the current situation in Iceland underscores, when things go wrong, they often go very wrong. Most carry traders buy the currencies of developing countries, such as Brazil, New Zealand, and Iceland, because they offer higher interest rates. However, these currencies are often far less liquid than those of developed countries, which means it can be very difficult to exit quickly and safely from a losing position. Capuchinomics.com reports:

In an environment of rising interest rates, carry trades using the Dollar, Euro and Yen will come under severe pressure.

Read More: Krona crisis drama prelude to carry trade tragedy