While emerging market currencies may have very high yields – for instance, the Turkish lira has a 11.5% yield and the Russian ruble has a 5% yield, developing market currencies tend to exhibit high bouts of volatility. Since the object of the carry trade is to hold two currencies to bank on the yield differential, quick currency movements are not desired.
Carry trades typically work best when the market is in a state of low volatility and a central bank raises its interest rates or plans to increase rates. In contrast, traders should be wary of interest rate cuts or central banks artificially depreciate their currency.
While traders may short a low-yielding currency and take a long position in a high-yielding currency, currency investors may also utilize funds that follow a carry trade strategy like the, PowerShares DB G10 Currency Harvest Fund (NYSEArca: DBV) and iPath Optimized Currency Carry ETN (NYSEArca: ICI), which both utilize long and short currency futures to capture the spreads on the risk-free yields between a basket of G10 currencies: Australian dollars, British pounds, Canadian dollars, euros, Japanese yen, New Zealand dollars, Norwegian kroner, U.S. dollars, Swedish krona and Swiss francs.
For past stories in this series, visit our “What is an ETF?” category.
Max Chen contributed to this article.