Hedge funds do it. Hungarian homeowners do it. Even Japanese housewives do it. They all make the so-called carry trade one of the biggest in global finance. It involves borrowing low-yielding assets in one currency and investing the proceeds in higher-yielding ones. The object is to capture the interest-rate differential.There’s one hitch: It’s a strategy increasingly at risk of falling victim to any number of potential mishaps. Rising Japanese and Swiss interest rates, a US hard landing, a slumping dollar, rising protectionism or a major geopolitical shock could dry up the oodles of cheap cash and credit fuelling world markets, compliments of your friendly central bank.

Those events may spark a sell-off of high-yield assets as investors become much more risk-averse, according to David Mouser, a money manager at Driehaus Capital Management in Chicago.

“A key driver of the excess liquidity has been the continued exploitation of the carry trade with Japanese and, to a lesser extent, Swiss rates remaining incredibly low, while the Federal Reserve and European Central Bank have continued to raise interest rates,” he says.

“A substantial risk is a misstep by either the Fed, ECB, or Bank of Japan regarding interest-rate policies,” Mouser says. “The biggest risk would be if the BOJ raises rates too quickly and reverses the carry trade too rapidly.”

An investor could have borrowed yen yesterday at an annual rate of 0.55 percent for three months and deposited the funds in a US, Australian or New Zealand dollar account yielding 5.3 percent, 6.5 percent and 7.7 percent, respectively. If the investor were more daring, he could have used his cheap yen to invest in Iceland, where the three-month deposit rate was about 15 percent, or Turkey, where it was 19 percent.

At about 2.10 percent for three months, Swiss interbank rates aren’t as low as Japan’s, though they are low enough to keep this interest-rate arbitrage game alive. The gap between Swiss rates and those in other countries “is almost an invitation” for carry trades, Swiss National Bank President Jean-Pierre Roth told reporters in mid-December.

Hungarian homeowners agree. In the second quarter of 2006, 74 percent of mortgage refinancing by FHB Mortgage Bank Nyrt., Hungary’s No. 2 mortgage lender, were denominated in foreign currency, overwhelmingly in Swiss francs, according to the bank’s preliminary report for the first half of 2006.

What’s more, Japanese housewives, who traditionally manage the family’s investments, make the Hungarians look like skinflints. Seeking higher returns abroad, Japanese retail investors have purchased 30 trillion yen ($247 billion) of foreign bonds since the Bank of Japan initiated its zero-interest-rate policy in 1999, according to JPMorgan Chase & Co. estimates.

What scares folks like Driehaus’s Mouser is that a large chunk of carry-trade bets are made with borrowed funds, and the low volatility in world financial markets has prompted investors to gamble more and more cash on smaller returns.

“One of our main calls for 2007 is an unwinding of the global carry trade against a background of increasing risk perception, as well as interest-rate cycles starting to converge by the end of this year,” says Valentin Marinov, a currency strategist at Dresdner Kleinwort in Frankfurt. “The current levels of volatility are so low that any upward correction would be considerable.”

The potential result? A seemingly benign trade morphs into a highly contagious, virulent money-loser that infects global financial markets.

“The fallout would look quite like that which happened last May, though much larger <\m> stocks falling, credit spreads widening, risky and illiquid assets going down and hedge funds performing poorly,” says Ray Dalio, chief investment officer at Bridgewater Associates Inc., a Westport, Connecticut-based money-management firm with $165 billion in assets.

A drop in asset prices and an increase in long-term bond yields could also damage the U.S. and other economies that have been recipients of the carry’s largess.

Commenting on the “euphoria on financial markets where investors don’t really want to see risks,” Swiss National Bank President Roth, in his December remarks, noted the growing appetite for carry trades. If the Swiss franc began rising, “it could trigger a lot of damage,” he said. “Financial-market investors and businesses should therefore be aware of the exchange-rate risks they take.”

Now that you have read the warning label, it might be time to hedge.

Bilal Hafeez, London-based global head of currency strategy at Deutsche Bank AG, recommends investors exit cash carry positions and switch to using options instead. The logic is that once carry trades blow up, currency volatility will become so high that it will be hard to get a bank to take a trade except at an unattractive price.

Hafeez says you can buy a put option <\m> the premium is about 2 percent for a 12-month contract <\m> on a basket of high- yielding currencies. If carry trades unravel and the high- yielding currencies fall, you make money. If they don’t, your loss is limited to the premium.

On the other hand, if you bet on the carry trade succeeding and want to limit your losses, you should buy a call option on the same basket. Again, if you are wrong, you only lose the premium.

Investors seeking insurance against the yen-carry trade going awry should consider buying Swiss francs while simultaneously shorting Swedish kronor, according to BCA Research in Montreal. The franc, regarded as a haven in times of crisis, would probably be bid higher and the krona lower, it says.

“It’s always prudent to have a contingency strategy in the event of an unexpected shock,” says Chen Zhao, the firm’s head of global strategy.

These tactical approaches may save some investors’ skins, though they will do little to alleviate the strains on the global financial system if the carry-trade bubble bursts.

(Michael R. Sesit is a Bloomberg News columnist. The opinions expressed are his own.)