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A Breakdown of the Carry Trade
The carry trade is a strategy in which a trader sells a currency that is offering
lower interest rates and purchases a currency that offers a higher interest rate. In
other words, you borrow at a low rate, and then lend at a higher rate. The trader
using the strategy captures the difference between the two rates. When highly
leveraging the trade, even a small difference between two rates can make the
trade highly profitable. Along with capturing the rate difference, investors
also will often see the value of the higher currency rise as money flows into the
higher-yielding currency, which bids up its value.
Real-life examples of a carry trade can be found starting in 1999, when Japan
decreased its interest rates to almost zero. Investors would capitalize upon these
lower interest rates and borrow a large sum of Japanese yen. The borrowed yen
is then converted into U.S. dollars, which are used to buy U.S. Treasury bonds
with yields and coupons at around 4.5-5%. Since the Japanese interest rate was
essentially zero, the investor would be paying next to nothing to borrow the
Japanese yen and earn almost all the yield on his or her U.S. Treasury bonds.
But with leverage, you can greatly increase the return.
For example, 10 times leverage would create a return of 30% on a 3% yield. If
you have $1,000 in your account and have access to 10 times leverage, you will
control $10,000. If you implement the carry trade from the example above, you
will earn 3% per year. At the end of the year, your $10,000 investment would
equal $10,300, or a $300 gain. Because you only invested $1,000 of your own
money, your real return would be 30% ($300/$1,000). However this strategy only
works if the currency pair’s value remains unchanged or appreciates. Therefore,
most carry traders look not only to earn the interest rate differential, but also
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capital appreciation. While we’ve greatly simplified this transaction, the key thing
to remember here is that a small difference in interest rates can result in huge
gains when leverage is applied. Most currency brokers require a minimum
margin to earn interest for carry trades.
However, this transaction is complicated by changes to the exchange rate
between the two countries. If the lower-yielding currency appreciates against the
higher-yielding currency, the gain earned between the two yields could be
eliminated. The major reason that this can happen is that the risks of the higheryielding
currency are too much for investors, so they choose to invest in the
lower-yielding, safer currency. Because carry trades are longer term in nature,
they are susceptible to a variety of changes over time, such as rising rates in the
lower-yielding currency, which attracts more investors and can lead to currency
appreciation, diminishing the returns of the carry trade. This makes the future
direction of the currency pair just as important as the interest rate differential
itself. (To read more about currency pairs, see Using Currency Correlations To
Your Advantage, Making Sense Of The Euro/Swiss Franc Relationship and
Forces Behind Exchange Rates.)
To clarify this further, imagine that the interest rate in the U.S. was 5%, while the
same interest rate in Russia was 10%, providing a carry trade opportunity for
traders to short the U.S. dollar and to long the Russian ruble. Assume the trader
borrows $1,000 US at 5% for a year and converts it into Russian rubles at a rate
of 25 USD/RUB (25,000 rubles), investing the proceeds for a year. Assuming no
currency changes, the 25,000 rubles grows to 27,500 and, if converted back to
U.S. dollars, will be worth $1,100 US. But because the trader borrowed $1,000
US at 5%, he or she owes $1,050 US, making the net proceeds of the trade only
$50.
However, imagine that there was another crisis in Russia, such as the one that
was seen in 1998 when the Russian government defaulted on its debt and there
was large currency devaluation in Russia as market participants sold off their
Russian currency positions. If, at the end of the year the exchange rate was 50
USD/RUB, your 27,500 rubles would now convert into only $550 US (27,500
RUB x 0.02 RUB/USD). Because the trader owes $1,050 US, he or she will have
lost a significant percentage of the original investment on this carry trade
because of the currency’s fluctuation - even though the interest rates in Russia
were higher than the U.S.
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