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The Carry Trade Demystified: Opportunities Abound

September 9, 2010

http://www.insidefutures.com/article/165818/The%20Carry%20Trade%20Demystified:%20Opportunities%20Abound%20.html

“The currency carry trade involves taking advantage of interest rate differences (that is, borrowing costs) between various countries. Each country’s central bank sets a key short-term interest rate target, which can differ greatly. Investors or traders will borrow currency at a lower rate, convert to a currency yielding a higher rate, and then lend it. To unwind the trade, they would convert the currency back. Traders around the world execute this strategy in a variety of ways to capture interest rate differential between economies. This causes cash to flow from economies with low interest rates into economies with higher rates, and that is what’s known as the currency carry trade.”
One of the biggest carry trades is between the Japanese yen and the Australian dollar. Japanese interest rates have been near zero for over a decade while Australian rates have been higher, often much higher. Investors have thus found it potentially profitable to borrow in Japanese markets, in yen at low interest rates, and then re-invest that borrowed money in Australia, in Australian dollars, at higher interest rates. The interest rate differential between the borrowing and investing rates allow for steady and easy profit.
“This strategy is not without risk. The most serious risk when you borrow money in one currency, convert it into another currency and then lend it in the higher rate currency is that the exchange rate will change to your detriment. For example, if you borrow yen, convert the currency into U.S. dollars, and then lend them at a higher U.S. interest rate, your risk is that the value of the yen will increase. That’s because you will have to reconvert U.S. dollars back to yen to unwind the trade. You might not have enough cash to pay out the loan if the currency appreciates too much. So you need both interest rates, and the currency’s value, working in your favor.”
1. How do differences in one nation’s central bank monetary policy versus another’s (e.g. Japan and Australia) lead to the ‘carry trade’?
2. What would happen to the demand for Japanese yen if Japan’s interest rates suddenly became equal to Australia’s? How would this shift likely affect the Yen/Dollar exchange rate?
3. How might the Yen/Dollar carry trade be affecting Australia’s balance-of-payments?
4. Does the carry trade have any economic purposes other than profit-making? What might they be?

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