How The Carry Trade Works: Currency Carry Trade Education
The basic premise behind how the carry trade works is interest rate differentials. Interest rates are periodically set by central banks in response to the prevailing economic conditions that are influencing the country. In essence, the currency carry trade is a strategy where the investor/trader sells a low yielding interest rate currency and uses the funds to purchase a higher yielding currency or asset. Hedge funds have been some of the prime beneficiaries from this approach. They typically borrow at ultra short term rates (Japanese Yen) and invest in longer term instruments that carry higher interest rates. The difference in coupons makes up for the cost of carry and returns a profit. When leverage is applied to this approach it can be very rewarding.
Who benefits from the Yen carry trade?
Bankers, traders, hedge funds and corporations have all benefited from the carry trade by borrowing at very low rates and investing in different asset classes including: commodities, debt instruments, currencies, commodities, foreign bonds, long term bonds and stocks. The amount of money invested in the global carry trade is considered to be huge at the time of time of this writing. Carry trade funding currencies have typically been the Japanese Yen and the Swiss Franc. This, however, has started to change. The US has drastically altered interest rates in recent times to 2.25% (tipped to go even lower at time of this writing) resulting in the US dollar becoming a potential funding side for the carry trade.
A practical example of the carry trade: Carry trade education
In the forex market, speculators buy high interest currencies and sell currencies that carry low interest rates. An example in this regard is the AUD/JPY pair whereby the interest rate for the Australian currency is 7.25% and the Japanese Yen 0.50%. If the market participant has a view that the Australian currency is likely to go up then he takes a long position to capture a potential price rise in the Australian currency relative to the Yen and also capture the interest rate differential. Each day this position is held, rollover interest is applied to the traders account. The basic premise is that the demand for the Australian currency, due to higher interest rates will drive up the demand for the currency and push up the price. This position requires an understanding of interest rate differentials and a good handle on the economic factors that influence the countries that comprise the currency pair. The trader stands to profit form the accredited interest and the profit from the appreciation of the Australian dollar relative to the Yen.
Unwinding of the Yen carry Trade
The actions of central banks to alter interest rates or a change in the factors that affect exchange rate stability can result in an unwinding of carry trade positions. The risk associated with the carry trade is that the foreign exchange rate will change and the market participant will be required to pay back more expensive currency with less valuable currency. In recent times, the unwinding of the carry trade has been a big factor affecting exchange rate and stock market fluctuations during the recent liquidity problems. Consider August 2007 and February 2008 as two prime examples of this happening. When markets and asset values plunge, carry trade participants unwind positions which contributes to overall market volatility. This can happen as a result of assets prices such as the board market or financial service securities adjusting due to adverse news. The Japanese to USD exchange rate, or the Yen relative to other currencies appreciates as investors and traders exit their positions. Many currency commentators have come to associate the carry trade as a global sentiment measure of risk. When the carry trade is put back on it is usually an indication that participants consider markets to be oversold and are therefore willing to take on the risk associated with new positions.
Interest rate differentials affect the carry trade and the currencies associated with it. With the current interest monetary policy pursued by the US Federal Reserve, US interest rates are declining at a rapid rate. This has prompted many to consider whether the US dollar will become a new carry trade funding currency. From a strategic perspective, US hedge fund managers and investors can consider prudent JPY investing (or investing USD in JPY). In the past, the JPY and US stock market has enjoyed a historical correlation as market participants borrow in Yen to purchase US securities. US interest rates can be predicted to impact the Japanese to USD exchange rate in the foreseeable future. Borrowing in Yen may cease to become attractive with the interest rate differentials between the US and Japan narrowing. This will have implications for global capital markets.
