The Carry Trade

What is a Carry Trade?

To put it in lay man terms, the process of selling currency at low interest rates and then using the money earned to buy different currencies at higher interest rates is known as carry trade. In this process you earn the money that is the difference between both interest rates.

You may make gains but without any guarantees

This is true. The very basis for this trade opportunity is the differential on interest rates. You also are dependent on a certain country’s economy for paying you these higher interest rates. At this point, it is best if you realize that the practical world does not offer you any guarantees.

The most popular lenders

Since the interest rates on the Swiss Franc and the Japanese Yen are one of the lowest they are the best currencies to borrow in the universe of carry trading.

Which currencies do you invest in?

If you are guessing that the US dollar is one of the best currencies to invest in then you will be thought of as a conservative trader. Some popular currencies to invest in include the New Zealand or Australian dollar. You can even consider other emerging economy’s currencies which promise you a high interest rate. But, you do have to be quite adventurous in order to do that.

What are the risks involved?

There are, of course, risks involved in this line of work. There are loads of them but then again which job does not involve risks? The only difference is that the losses in this case may be enormous. The number one risk you face is that the currency in which you borrow appreciates. This will wipe out any difference between the high interest rates and the low borrowing rates on any of your investments. There are many cases where investors have had to sell their high return assets just so that they could repay their Yen debt because it was appreciated. The markets also are aware of this factor which is why they take it into account when determining the price of each currency. This results in overreactions.

There are many risk mitigating factors too

The Yen did not appreciate quite as much as it was expected to. This is because most carry traders were of Japanese origin and they sold their Yen as soon as it appreciated thus counteracting the purchase of Yen by foreign speculators. Japanese traders expect their government to intervene if the value of the Yen appreciates so that they can protect their exports.

The challenges

The 3 currencies that get overvalued because of carry trade are the Australian Dollar, the Great Britain Pound and the New Zealand Dollar. These currencies lose upto five percent of their value inside a week if there is even a moderate stirring in the market. The factors that usually cause this include the deficit in New Zealand and Australian trade. A UK trade isn’t all that better either.

Finally

Even though it is against normal belief, the fact is that the largest profits in this trade come from appreciation in high yielding currencies and not from difference in interest rates. You should therefore sell if the currency you invest in gains value. After this, you might lose money for a little while. You might not gain quite like you could have.