Carry trade in simple terms means borrowing in one currency where the interest rates are low and investing this loan money in high yielding assets some where else. A classic example of this is the carry trade going on since so many years using the Japanese Yen as the borrowing currency. Interest rates in Japan have been at near zero percent since the last 7-8 years. Traders all over the globe have taken Japanese Yen loans at very low interest rates and invested the same in other potential high assets like equities, commodities, real estate, government bonds, art, gold etc all across the globe. A simple example of this can be taking a loan in Japanese Yen at say 0.50% and converting this money into US Dollars and investing it in US Treasuries yielding say 2%. Due to the difference between the interest earned (2%) and the borrowing interest rate (0.5%) the trader makes a clean profit of 1.5%. This might look like a risk free trade and the most lucrative one. But hold on. Currency exchange rates may play spoilsport in this trade which seems risk free in the first look. We will see this later how currency exchange rates play a very important role in carry trade.
The currency in which the loan is taken is known as the funding currency in carry trade. In the above example the loan is taken in Japanese Yen. Hence the Japanese Yen is the funding currency. Other currencies apart from the Japanese Yen which have been popularly used as funding currencies are the Swiss Franc and the most recent one to gain popularity as funding currency is the US Dollar.
The currency which is bought using the funding currency is known as the investment currency in carry trade. In the above example the loan is taken in Japanese Yen and then later this currency is sold to buy US Dollars for investment in US Treasuries. Hence in this case the US Dollar is the investment currency. Countries where interest rates are high or where asset classes like equities, commodities, real estate, art etc have the potential of yielding high returns, their currencies are popularly used as investment currencies. Some popular examples include New Zealand, Australia and even India where interest rates are high compared to the developed world. Traders use the interest rate arbitrage (difference in the interest rates) between the two countries to benefit from the carry trade.
Dollar Carry Trade
Since the beginning of 2009 the US economy has been going through the worst economic crisis since The Great Depression of 1929. To pull its economy out of the recession the US Government announced a huge stimulus package. This added to the already burgeoning deficit of the US. At the same time the Federal Reserve cut key interest rates to near zero levels to make liquidity easily available. A weak economy, huge deficit and near zero interest rates have led to fall in the value of the US Dollar against a basket of major currencies over a period of time. With money available easily and cheaply in the US and attractive high yielding investment opportunities available in other economies, traders have started borrowing funds in US Dollars and investing them else where for attractive returns. The volume of such trades have become fairly large in the recent past considering lot of people have got involved in such trades. In effect the US Dollar has become the funding currency for these trades and the carry trade has shifted from the Japanese Yen to the US Dollar as the funding currency of choice.
Profiting from Carry Trade
With the volume of carry trade so huge you must be wondering how a person profits from such a trade. There are two ways in which a person can make gains from carry trades.
- Interest Rate Difference
- Funding Currency Depreciation against the Other Currency
Let us take an example to understand this better. Let us assume a person Mr. X takes a loan of USD 1 from the US at an interest rate of 2% for one year. X brings this 1 USD to India and sells it and converts this to Indian Rupees. Let us assume that the USD : INR conversion rate is Rs 50 at that time. So X takes this Rs 50 and invests them in Government Bonds at say 6%. At the end of the year the loan will have to be repaid. Let us see how X will profit from this trade.
- Interest Rate Difference: The loan has been taken at an interest rate of 2% and invested in a bond that yields 6% interest rate. So the difference between the interest rate earned (6%) and the borrowing interest rate (2%) is the gain. In this trade the gain is 4%.
- Funding Currency Depreciation: The USD : INR exchange rate at the time of closing the trade will play the all important role of deciding the overall profit or loss that will be made in this trade. Let us assume 3 scenarios of the USD : INR exchange rate at the time of closing the trade.
- No Change: In the 1st scenario let us assume that at the time of closing the trade the USD : INR exchange rate is the same as it was at the opening of the trade. In this case the USD : INR conversion rate will be Rs 50. So at the time of converting the principal amount of Rs 50, Mr. X will get 1 US Dollar. So the profit will only be the interest rate difference of 4% as there is no change in the USD : INR exchange rate.
- Funding Currency Depreciation: In the 2nd scenario let us assume that at the time of closing the trade the funding currency (USD) has depreciated by 10% against the other currency (INR). This in other words means the Indian Rupee has appreciated by 10% against the US Dollar. This means now 1 USD is equivalent to Rs 45 (Rs 50 – 10% of Rs 50). So at the time of converting the principal amount of Rs 50, Mr. X will get (50 / 45) USD 1.11. The original principal amount was USD 1. So the extra USD 0.11 is the profit made by X due to the depreciation of the funding currency against the other currency, apart from the 4% profit due to the interest rate difference.
- Funding Currency Appreciation: In the 3rd scenario and the most important scenario let us assume that at the time of closing the trade the funding currency (USD) has appreciated by 10% against the other currency (INR). This in other words means the Indian Rupee has depreciated by 10% against the US Dollar. This means that now 1 USD is equivalent to Rs 55 (Rs 50 + 10% of Rs 50). So at the time of converting the principal of Rs 50, Mr. X will get (50 / 55) USD 0.90. This is less than the original borrowed (Principal) amount of USD 1. The original principal of USD 1 is now worth only USD 0.90 due to the appreciation of the funding currency (USD). So even after taking into account the 4% profit made due to the interest rate difference, still after taking into account the 10% appreciation of the funding currency, X will end up with a loss in this trade. So in effect the funding currency appreciation has even wiped out the risk free profit made due to the interest rate difference (4%) and resulted into an overall loss in the trade.
So for the traders to make a profit from a carry trade 2 things are very important:
- The return earned from the investment made through the investment currency should be higher than the borrowing cost of the funding currency.
- The exchange rate of the funding currency should remain same which is hypothetical. If there is depreciation in the value of the funding currency it adds to the profits of the trader. Depreciation of the funding currency works to the advantage of the trader. If the funding currency appreciates against the investment currency if can wipe out profits of the trader and can even result in overall loss in the entire trade. So appreciation of the funding currency works to the disadvantage of the trader.
Unwinding of Carry Trade
From the above 2nd point we can see that traders need to keep a close watch on the movement of the funding currency. If the funding currency appreciates very sharply in a very short span of time it will result in heavy losses for the trader. So what does the trader do in this case? This brings us to another important aspect of this topic. To cut his losses the trader will have no option but to close his trade. This phenomenon of closing the trade is known as ‘Unwinding of Carry Trade’. At the time of unwinding the carry trade, the trader does a reverse trade. In other words, in case of the above example, it means that the trader will sell the bond and convert the Indian Rupees into US Dollars and repay the borrowed US Dollar loan.
Surge in US Dollar Carry Trade
Traditionally the Japanese Yen has been the funding currency of choice for traders all over the globe for carry trade. But off late the US Dollar has replaced the Japanese Yen as the funding currency of choice for carry trade. So what is it that has made traders to switch from the Japanese Yen to the US Dollar to fund their carry trades? There are few reasons for this:
- US Deficit: Since the last few years the US Deficit has been increasing steadily. The huge stimulus announced by the US Government has only aggravated matters by increasing the deficit by a big proportion. A high deficit keeps the currency of the country under pressure. So the US Dollar has been steadily depreciation against the Euro and the basket of major currencies.
- Interest Rates: The interest rates in the US are near zero percent. This has been done so that there is enough liquidity in the financial system and that too at low rates so that it can spur economic growth. Low interest rates again keep the rise of the currency under check.
- Economic Recovery: With the US economy a long way away from returning to sustainable economic growth, the US dollar will continue to remain weak.
- US Government Policy: The government policy is in favour of a weak US Dollar. Depreciating currency makes exports of a country more competitive vis-à-vis other countries. The US authorities are in favour of an orderly decline in the value of the US currency to a certain extent.
Due to the above reasons the outlook for the US Dollar looks grim. Infact the US Dollar may continue to slide against the Euro and other major currencies in the near term. Also there is abundant liquidity in the US financial system and is available at near zero percent interest rates. So the weak prospects for the US Dollar along with cheap money availability make the Dollar a perfect choice for traders to use it as a funding currency of choice for their carry trades.
Negative side of Carry Trade
The unwinding of carry trade due to appreciation of the funding currency can have ripple effects. Over the years Japanese Yen was borrowed heavily and invested in all possible asset classes like US Treasuries, equities in Emerging Markets like India, Brazil, China, Russia etc, Real Estate in Hong Kong, Singapore, Commodities like gold, crude oil etc. A sudden surge or appreciation in the funding currency can lead to unwinding of carry trade. And this can lead to a major sell off in asset classes like equities, real estate, commodities, art etc leading to heavy losses for investors. In 1998 the Japanese Yen appreciated by 20% in two months and this led to a heavy sell off in asset classes all across the globe by traders who had exposure to Yen Carry Trade. So investors need to exercise caution before taking the decision to indulge themselves in carry trade.
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