Over the past few years, the carry trade has been a major talking point in the financial markets. It is often mentioned in the news because a large number of investors use it as a trading strategy. The strategy is based on the economic theory of supply and demand since funds tend to flow into countries that have a higher return on investments.

Simply put a carry trade is where a trader borrows money in a low interest currency (e.g. the Japanese Yen) and buys assets in a high-yielding currency (e.g. the Australian Dollar, NZ Dollar, or the Brazilian Real). For example, if a trader was to sell the JPY and use the funds to buy the New Zealand dollar (NZD) the interest differential would equate to 7.75%.

Interest rate for the Yen is 0.05% and interest rates in New Zealand are 8.25% (8.25% – 0.05%). Therefore if a trader invests $10,000, he or she would earn 7.75% on this carry trade per year, which is $775. With the use of leverage as provided by all foreign exchange providers, this return can be increased a hundred fold. The result is that for the past decade the carry trade has become a staple for investors and has encompassed just about every financial instrument available.

So when do carry trades work? When central banks increase interest rates or plan on increasing rates and/or in a low volatility environment. An increase in rates sees a flow of funds to the rate rising economy. With this increasing capital flow there is an appreciation in the country’s currency value since the funds used need to be converted to the country’s currency to facilitate investment.

Additionally, in a low volatility environment traders are prepared to take risks since the expectation is of minimal currency fluctuations thus, the investor earns the leveraged yield. By now you would have realized that we are in exactly the opposite situation. We are currently witnessing major fluctuations in the financial markets due to the credit crisis stemming from the United States.

As a result of these movements, many of the central banks (particular the Federal Reserve) may be forced to lower interest rates in order to try and normalize the markets. This movement downwards with regard to rates and the uncertainty of banks exposure to the crisis coupled with the fact that most of the carry trade money has flowed into risky cyclical assets (typically mortgage assets) has seen many traders unwinding their carry trades and repaying their yen debt.

This flow of funds back to yen causes the yen to appreciate in value and thereby increase the borrowing costs of debt still outstanding and correspondingly reduces the returns on any open carry trade positions.

Keeping what I have said in mind, then in theory, the only way for a trader to benefit from carry trades would be through a basket of currencies. By having an exposure in several high yielding currencies, the trader allows for one central bank to lower rates while still allowing the remaining currencies to benefit from the higher interest rate yields.

However, theory seldom equates to fact, as can be witnessed by the current declining Australian dollar. Simply put, expectations still exist for a possible rate increase given Governor Stevens comments recently on the Australian economy that inflation was likely to remain uncomfortably high in the near term. However, the dollar has continued to fall.

For anyone interested in the carry trade, the view must be in the long term. A true carry trade means that the investor needs to be able to ride out these currency fluctuations. Wisely, few retail investors have the inclination or the capacity to ride these peaks and troughs.

Robert Francis, General Manager, Easy-Forex

Disclaimers: The views expressed in this article are those of Robert Francis, a representative of Easy-Forex and is not intended as general advice. This does not constitute a recommendation nor does it take into account your investment objectives, financial situation nor particular needs.