Wednesday, February 28, 2007

Word of the Day: Carry Trade

Carry trade is a trading strategy where you borrow money at one interest rate, and invest that money in something that (you hope) gives you a higher rate of return.

Typically, I would expect that carry trade opportunities would quickly quickly disappear as everybody piles in to make a quick buck, and the resulting dynamics tends to an equilibrium with negligible profits.

But one form of carry trade has become hugely popular in the past 5 years - Currency carry trade. To do currency carry trades, you will need to -
-- Borrow local currency in a country with a very very very low interest rate (Japanese yen at 0.25%)
-- Sell that currency and buy currency of another stable country that has a high interest rate (US$ at 5.25%)
-- Buy short-term sovereign (risk-free) bonds in the high-interest-rate currency
-- PROFIT!!!

When you look at interest rates in Japan vs. US, there seems to be an opportunity to make a risk-free profit of around 5%. This is what international financial firms and hedge funds with access to both markets have been doing for the past 5 years. And they do this with a lot of leverage (say 10:1) such that after borrowing X yen, they get a return of 50%, not 5%.

Since there is no free lunch, there must be a catch somewhere. This comes from F/X risk. If the value of the yen rises against the US$, when you try to buy back yen to repay your loan, your profits are wiped out. The losses are magnified (like your profits) if you have used leverage, as you still need to repay your loan. This is what should be happening if everybody starts doing currency carry trade.

Now carry trade has been very profitable and almost risk-free for everybody involved for the past 5 years.
-- Japan had been injecting liquidity into their market with a zero interest rate policy (aka printing money) to get out of their liquidity trap.
-- In order to simulate Japanese exports, the Japan Central Bank has been furiously buying US$ bonds (increasing US$ demand and value) to keep the value of the yen artificially low.
-- The cash era all over the world since 2001 has lead to a glut of liquidity with historically low volatility which has allowed very easy and cheap leverage

The net effect is that asset classes all over the world have risen over the past 5 years due to surging demand due to high liquidity.

This might all be about to change.

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