ANALYSIS-FX carry bets still on, as long as you're selective

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LONDON, July 11 (Reuters) - The Japanese yen's rally this week has spooked investors in a show of how seemingly fool-proof profits from "carry trade" investments can be wiped out, but there is still money to be made for those who pick trades carefully.

Investors can still borrow cheaply in low-yielding currencies to fund purchases of higher return ones, particularly in emerging markets, as long as they are aware of the inherent economic, financial market, and potential political risks.

For example, the Brazilian real could replace the New Zealand dollar as a vehicle for lucrative investments, while the Czech crown may be a better than the yen for cheap borrowing.

"There are still carry trade positions that can make money, but from now on customers will have to be far more selective," said Adam Myers, currency strategist at UBS.

The carry component of Deutsche Bank's currency return index has earned a dollar return of 13.2 percent for the year to date, far outperforming investments based on valuation or momentum.

But this week's pick up in risk aversion, sparked by worries that U.S. subprime mortgage market woes may hurt the wider economy, is the latest in a series of warning signals for carry trade aficionados over the past month.

New Zealand's central bank intervened directly in the market for the first time since it floated the kiwi over 20 years ago to knock the unit off two-decade peaks, the Bank for International Settlements voiced concern about the weak yen and Japanese policymakers keep warning against one-way currency bets.

BETTER BETS

But while this has spooked some investors, others are looking for less well-worn carry pairs, including those on offer outside the developed world.

Caution is needed as high interest rates often go hand in hand with high inflation and financial risk, while emerging markets pose a host of other potential pitfalls.

The currencies are not as liquid as the "majors", which means it may be harder to exit or enter a trade and you may have to sacrifice on price.

For example, nearly $18 billion worth of New Zealand dollars are traded daily, compared with around $4 billion for the Brazilian real and less than $2 billion for the Turkish lira, the latest triennial FX survey from the BIS in 2004 showed.

Reduced liquidity can also mean higher volatility and thus greater risk of unexpected, carry-unfriendly currency moves and higher cost of betting on the market via options, whose price premiums include a volatility component.

According to JP Morgan an emerging market carry trade basket had volatility of 7.3 percent over the past decade -- a touch higher than the G10 basket at 6.1 percent. But it also offered more than double the returns -- 14 percent versus 6.1 percent.

So taking higher risks can pay off through higher returns.

"Some currencies are going to be vulnerable to swings in global risk appetite (like) the South African rand," said Jon Harrison, emerging market strategist at Dresdner Kleinwort.

"But there are other carry trade currencies where there is much stronger support from fundamentals like the Brazilian real, and to some extent for central Europe."

Myers at UBS also highlighted the real , which enjoys rates of 12 percent, and mentioned the lira whose benchmark borrowing costs stand at 17.5 percent.

Among the funding currencies, the Czech crown remains an attractive option, offering rates of just 2.75 percent, although a rate hike is expected later this month.

REDUCING RISK

Investors can limit their exposure to risks associated with individual emerging markets through diversification.

Research from Goldman Sachs suggests portfolio investments offer a better risk/reward ratio than any single carry trade pair, while JP Morgan recommends an equally weighted G10/emerging basket.

Alternatively, rising interest rates in the industrialised world are opening up new opportunities for carry which -- thanks to their newness -- are less overbought and thus potentially less vulnerable to sharp corrections.

The Norwegian crown and the Canadian dollar both enjoy rates of 4.50 percent, are both liquid currencies relative to emerging market counterparts and should also benefit from a strong global economy and any rises in energy prices. Norway's rates are seen rising at least twice more this year and even further in 2008.