The big risk during a carry trade is that 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 danger of losing money. Also, these transactions are generally through with tons of leverage, so a little movement in exchange rates may result in huge losses unless the position is hedged appropriately.
An effective carry trade strategy doesn’t simply involve going long a currency with the very best yield and shorting a currency with rock bottom yield. While the present level of the rate of interest is vital , what’s even more important is that the future direction of interest rates. For example, the U.S. dollar could appreciate against the Australian dollar if the U.S. central bank raises interest rates at a time when the Australian financial institution is completed tightening. Also, carry trades only work when the markets are complacent or optimistic. Uncertainty, concern, and fear can cause investors to unwind their carry trades. The 45% sell-off in currency pairs like the AUD/JPY and NZD/JPY in 2008 was triggered by the Subprime turned Global Financial Crisis. Since carry trades are often leveraged investments, the particular losses were probably much greater.