Profiting from the Carry Trade

Cross ref from http://awanginvest.com/?m=200808

August 20, 2008 – 12:00 am

Monthly chart of NZDJPY -inflows of carry trades

The carry of an asset is the return obtained from holding it , if positive, or the cost of holding it , if negative.

Commodities are usually negative carry assets because of storage costs but they can be positive carry assets as the market is willing to pay a premium for availability.

This can also refer to a trade where one can earn the spread between borrowing a low carry asset and lending a high carry one.

Carry trades must not be confused with arbitrages. Pure arbitrages make money no matter what. Carry trades make only only if nothing changes.

For example, traditional income stream from commercial banks is to borrow cheap at low overnight rate which they pay depositors and lend expensive at the long term rate.

This works in an upward yield curve but when the curve becomes inverted, it loses money. The floating of short term rates when Paul Volcker was chairman of the FED was a case in point.

According to a popular anecdote, traditional commercial banking can be characterized as a ‘3-6-3′ business - borrow at 3%, lend at 6%, earning 3% spread and be on the golf course by 3pm.

The carry trade from the point of view of traders refers to currency carry trade . Investors borrow low-yielding and lend high-yielding currencies. This tends to correlate with global financial and exchange rate stability and retracts during global liquidity shortages.

The risk is that foreign exchange rates may change so that investors would have to pay back more expensive currency with less valuable currency. Carry trades weaken the target currency because investors sell the borrowed sum and convert it to other currencies.

For example, the yen currency pairs have become the speculators’ pair du jour.

Since the late 1980s, the Bank of Japan had set Japanese interest rates at very low levels making it profitable to borrow the yen to fund activities in other currencies such as subprime lending in the US, emerging markets and resource rich countries.

Let us look at NZD/JPY, one of the favoured pairs now. Here a carry trader would borrow the yen @ 0.5% and then convert it into NZD. After the conversion, the trader would then buy a Kiwi bond for the corresponding amount, earning 8%. Therefore the investor makes a 7.5% return on the interest alone after taking into account the 0.5% that is paid on the yen funds.

The investor is also hoping that the price will appreciate to make more on the transaction. For 2007, traders were able to benefit from a 7.5% return as well as from a currency appreciation of 20.6% since the beginning of the year on the NZD/BPY transactions.

ANA aka IDKIT

Ag Moderator

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