Investors should follow trends in crises and shun carry trades as borrowing in currencies with low yields to invest in those with higher rates may lead to major losses, the Bank for International Settlements said.
Carry trades handed investors a 12 percent loss in January 1998 during the Asian crisis that started in the previous year, and a 6 percent decline in October 2008 during the latest financial crisis, BIS said. Momentum strategies, which bet currencies that appreciated or weakened most in the recent past will continue to do so, generated gains during the same periods, BIS said.
“The carry trade is a typical ‘nickel’ strategy yielding small gains most of the time, but exposing an investor to large losses,” the BIS said in its Quarterly Review. “One bad month can be sufficient to wipe out one or two years of average returns. In contrast, momentum strategies, in addition to downside risk, also have substantial upside.”
The performance of carry trades where investors sell currencies with low interest rates to buy ones with higher yields also suffered severe losses in August and September this year, in line with previous distress episodes, the BIS said.
“The largest loss of a carry-trade portfolio funded by U.S. dollars over these two months amounted to about 3 percent on a single day,” the report said. “This reflects the fact that carry trades target currencies, such as the Australian dollar, Brazilian real and South African rand, depreciated strongly whereas the dollar appreciated against the vast majority of currencies.”