The carry trade is a strategy used in foreign exchange dealings whereby a speculator will purchase high interest currency and sell low interest currency. What this achieves is to guarantee a return of some form to the investor due to the roll-over interest being posted to their account at the end of each trading day.

It can therefore also provide a significantly enhanced return depending on the exchange rate fluctuations.  The risk is less during periods of exchange rate stability and higher when exchange rates are fluid. Large losses can be made if not appropriately hedged, since if the cost of the borrowed currency increases relative to the currency purchased with it, the investor will have to pay back an expensive currency with one that is less valuable. An example indicates how this works more clearly.

An investor might borrow 10,000 interest free Yen, convert them to US dollars and purchase a bond that pays 4% interest.  The trader is liable to make 4% if the exchange rate remains constant.  In fact, many traders use leverage to increase the profit potential, and if a leverage factor of 10:1 is used, the investor can make a profit of 40%.  However, if the dollar falls relative to the yen,  money can be lost since the original loan will have to be repaid with a now less valuable dollar.  

The yen was chosen because that currency is a very popular one for carry trade investors. However, carry trade need not be confined to currency, and is basically purchasing an asset at one interest rate, selling the asset and converting the acquired funds into another asset with a higher interest rate.  In these terms, the risk is that of the initial borrowed asset increasing in value in comparison with the purchased asset. 

If that increase in value is not offset by the difference in interest rates, then the trader will make a loss.  Since high sums of money can be involved in these deals, then the sums lost can be significant.  The profits attainable from this type of trading are not predictable because the very act of carry trading can weaken currencies through them being sold to covert into other currencies.  The effect of this cannot be estimated, but profits can be very high indeed.

The problem with the carry trade right now is that interest rates are being normalized around the world, after a severe reduction in order to support the growth needed after the bursting of the dotcom bubble in 2000.  Interest rates in the UK are steadily increasing to reduce the inflation associated with sustained growth and the USA is not far behind them. 

If this trend extends to Japan, where steady growth has just begun, then the end of zero interest rates for the yen will likely result in its appreciation, which in turn will begin to corrode the favorable conditions that made the yen a target for the carry on traders.  This form of extremely cheap credit has already been switched off in many parts of Europe, including Switzerland, Sweden and the Euro countries.

Markets throughout the word could be devastated when the yen carry trade ends, since there is still a great deal of money involved that has not yet been unwound.  Any area containing speculative money, such as real estate, high yielding currencies and even art investment could crash when cheap credit disappears.

However, that time is not yet with us, and although the yen is steadily increasing in value against the dollar, the carry trade is likely to continue for the foreseeable future.  Interest rates on the yen, while no longer zero, are still ridiculously low enough to persuade carry traders to continue with business almost as usual.

The ‘almost’ is because a slump in some foreign stocks is tending to indicate that some traders are selling foreign investments in order to allow them to repay their yen loans before the rates rise further.  The situation is by no means stable and anybody entering the yen carry trade at this time will have to be sure of what they are doing. For the time being, however, it remains an attractive trading strategy.

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