Carry Trade

What is a Carry Trade?

In general terms the carry of an asset is the positive return received from holding it. For example, the interest received from a term-deposit account.

Alternatively, the cost of an asset is the negative return obtained from holding an asset. An example here is that commodities (sugar, rice, coal) incur storage costs and therefore a negative return.

Holding a commodity asset would only earn a positive return if the commodity price rose far more than the cost of storage. The term 'carry trade' refers specifically to interest rates and currencies.

Interest rates, put simply, refer to a fee the borrower is charged for borrowing money. The fee, or interest component, is the amount the lender is compensated for the loan of their money to the borrower. Each country sets its own interest rate, theoretically based upon the money supply and inflation. A currency is a unit of exchange from which a country or region facilitates the transfer of goods and services. So what does this all have to do with carry trades.

In its original form, a carry trade refers to an investor borrowing money from a currency with a low interest rate and lending it to countries with currencies with higher interest rate. For example, the Japanese interest rate has been very low, around 0.5% as compared to interest rates in other countries, like Australia. So people would borrow money from Japan at 0.5% interest and deposit that amount in, lets say for example Australia and earn a higher percentage return and pocket the difference as profit. Others with a little more appetite for risk may invest it in something like Icelandic Housing Bonds that may yield a 10% return. There are also carry trades available with even more risky emerging countries. How easy does that sound? Almost sounds too good to be true.

There is one other variable that needs to be considered, that is the currency exchange rate. Adverse movements in currencies will eat away and your profits or even worse incur a loss. For instance, if you take the first option of borrowing from Japan and investing in Australia, a rise in the Yen as compared to the AUD would cause imbalance. All of the investors involved in that carry trade would probably panic, trip stop loss levels, and therefore pull out of the Australian investments. They would then have to repay the Japanese banks the original loans, causing further upward pressure on the Yen and downward pressure on the Aussie dollar.

It is thought that around US$1 trillion is involved in the Japanese carry trade. Generally that is why upwards movements in the Yen are quite steep as international investors scramble to repay their debts. When currency and interest rate markets remain stable investors will benefit from this trade. However, recently investors have been borrowing money from Japan and investing it in riskier asset, such as shares. This is what caused the panic sell off in the mainland Chinese share market in 2007. Similarly, the carry trade fell out of favour during the financial crisis of 2008 with the likes of the $A falling from a peak of US98c to US60c in 4 1/2 months.T he carry trade can be rewarding, but also dangerous as well.