What is The Carry Trade?
What is The Carry Trade and How Does it Work?
"The Carry Trade" has been in the news a lot over the last few years, in the financial press at least, but what is it and how does it work? The Carry Trade is a favouite strategy of hedge-fund managers, how can small investor or trader do a carry-trade or at least take advantage of it?
The Carry Trade was popular with Japanese house-wives (and hedge-funds) when the Yen was yielding next to nothing and other currencies such as the US and particularly the Australian dollar were yielding far more, but now many governments around the world, especially the US and UK, have used economic stimulus (Quantitative Easing or QE) to help escape from the Credit Crunch the US dollar is now one of the lowest yileding currencies and is now the main currency used for this trade. Here is an explanation of how this "Easy Money" strategy works and how to understand its implications for you.
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So What is The Carry Trade?
The Carry Trade is the name given to the simple act of borrowing in a low yielding currency and using the borrowed money to buy higher yielding assets or currencies. The reason it is in the news is that it is very big business, especially when some some countries are using a lot of economic stimulus (like USA and UK etc.) which results in inter-bank lending rates being very low (even if we can't necessarily borrow the money so cheaply)
At the time of writing the official interest rates in USA, UK and Europe have never been lower because of economic stimulus (Quantitative Easing or QE) and the actual rates available for banks and other financial institutions only slightly higher, although other countries such as Australia and Israel are already increasing their interest rates. in the UK the base-rate is just 0.5% and Libor, the official London Interbank Offered Rate is just over 0.6% (and actual rates achieved depending on the institution and purpose) is a little above that and in the US rates are even lower than that. Corporate and Government Bonds are yielding far more than this as are most other currencies around the world.
So that's easy money! How can I take part in this free money experiment? Unfortunately this free money is being given to the financial services industry to get them out of the mess they have caused and they are using it to speculate and rest of us are unlikely to be able to borrow money at such a good rate to take advantage of this, but there are some opportunities and we can at least benefit from understanding it and knowing where it may take the markets.
So How Can I Benefit From The Carry Trade?
What rate can you borrow at? and what assets can you buy that yield more than that? If you cannot identify a pair of assets that will make you money or for which there is too much risk, then you can't benefit from a carry trade. If however your mortgage rate is very low and rates from other assets high (e.g. other currencies or bonds or defensive high yielding shares), then extending the mortgage or at least not paying it off and instead investing could be profitable, but be careful and don't bet the house on a the latest investment fad.
Understanding the Implications of the Carry Trade.
O.K. So it's easy money, but anything that seems too good to be true probably is and at some point it must come to an end. Economic stimulus (Quantitative Easing or QE) in many countries has already stopped and will stop eventually in the US and UK eventually, which will cause the hedge-funds to have to cancel their trades quickly or lose lots of money. The dollar is weak partly because of the financial mess that still needs to be flushed out of the system, but also because of the carry trade which has the effect of pushing down the currency in question and forcing up the other assets being speculated on. So arguably the dollar is too weak relative to other currencies, it could get weaker but if the carry trade stops suddenly people who have bet against it could get burnt.