Carry Trade
One of the most popular types of investments among forex traders is the so-called ‘carry trade,’ in which investors borrow one currency that charges a low interest rate and purchase a different currency that offers a high interest rate. The goal is to profit from the interest rate differential (the gains from lending minus the cost of borrowing). In times of loose monetary policy and simultaneous forex stability, carry traders can extract enormous profits. However, as the current situation in Iceland underscores, when things go wrong, they often go very wrong. Most carry traders buy the currencies of developing countries, such as Brazil, New Zealand, and Iceland, because they offer higher interest rates.
The strategy, which involves selling lower-yielding currencies, such as the yen, to fund the purchase of higher-yielding assets elsewhere, was popular among investors ahead of the financial crisis.
The strategy rests not just on interest differentials, but also on stability in asset markets since a sharp fall in the value of an investor’s target investment can wipe out any yield advantage of funding through a low-yielding currency. Indeed, the turmoil on financial markets saw investors scramble to unwind carry trades as asset prices plunged. This deleveraging sent the yen sharply higher
Table of Contents
How it works:
The "carry trade" is basically an interest arbitrage speculation. Investors (speculators) borrow money in a country with low interest rates, and then invest that borrowed money overseas in countries that pay higher interest rates. For example, an investor (speculator) could borrow money in Japan at low interest rates, and then invest that money in Brazil at higher interest rates. By keeping that money in a faster growing deposit account, the investors hopes to make more profit than could be made at home. Then, at the end of the time period, they will take the money out of the foreign account, bring it back home, and pay off the local bank. In this example, paying back the Japanese bank from which they originally borrowed the money.
Risks to the investor:
The risk, obviously, is that the currency exchange rates may change. If the value of the Japanese Yen were to suddenly appreciate, then the amount you owe (account payable) would grow, meaning that you would suddenly owe more money than you anticipated. On the other hand, the currency that you invested in (Brazilian Real in this example) might suddenly depreciate, making your gain smaller.
Effect of this trade on Foreign exchange rates:
If enough investors do this "carry trade", then the sheer volume of trades can move the exchange rates of countries. How? Because when you borrow yen to invest in foreign currency, that also means that you must sell yen in the foreign exchange market (and purchase the foreign currency). You sell Yen and purchase Brazilian Reais in order to invest in the Brazilian Real-denominated deposit account. By the simple laws of supply and demand, that act of selling Yen will put downward pressure on the value of Yen (depreciation of the Yen will result, along with appreciation of the foreign currency).
When does this trade make sense?
Investors (speculators) only take advantage of this type of "carry trade" as long as both of two conditions are met; (a) foreign exchange rates need to be relatively stable, and (b) investors must have a willingness to take on the necessary risk to conduct this trade.
As long as investors think the value of the Yen will remain low (and will not suddenly appreciate), then they will be more willing to borrow Yen to invest abroad. But, if expectations increase that the Yen will appreciate, you will find many investors suddenly running to "unwind" or un-do their speculation in this carry trade.
Perhaps the most critical element that must exist in order for this trade to exist is for traders to have a healthy appetite for risk. If, on the other hand, investors suddenly loose their appetites for taking on risk (speculation on currencies is extremely risky), then you will see investors walk away from (or "unwind") their carry trade positions.
Credit Crisis leads to an "unwinding" of the carry trade
As a direct result of the (never-ending) credit crisis in the United States (and now globally), we have seen a trend whereby investors have decreased their appetites for risk, and have taken the "flight to safety", wherever they can find it. One interesting place that investors have discovered as a potential "safe haven" from the US based credit crisis is in Japan. While the US banks were busy getting into exotic derivatives trading in the 90's-2000's, the Japanese banks were just recovering from their own financial crisis, and were therefore avoiding these more innovative financial products. This has left many to believe that Japan has been insulated from the effects of the credit crisis, and has left their banks well positioned to navigate this financial storm.
But, perhaps the most important factor in unwinding the "carry trade" has been the global decision to try and preserve cash and to avoid risk. With this targeted reduction in risk, there has been a shift away from risky trades (such as borrowing Yen to invest in foreign currencies).
What is the effect on currencies?
As big commercial banks unwind their carry trade positions, there has been the reverse effect on global currencies. Now, instead of borrowing money in Japan to invest overseas, we are seeing investors bring money back to Japan to pay off their borrowing. So, rather than selling Yen to purchase foreign currencies, we are seeing investors sell foreign currencies to purchase Yen.
So what is the effect? Japanese Yen appreciates, foreign currencies (that were involved) depreciate. This happens with all currencies that were being used as a carry trade. Some examples could include Brazil, Turkey, Iceland, etc....any of the high-yielding currencies that were a "carry trade" partner with the Japanese Yen.
What is the effect on foreign trade?
The real question to ask with all of this is....so what? What does all of this mean to your average company in any of these countries? The answer is that it has a huge effect. In the case of Japan, if the carry trade were to unwind, and if investors were to stop selling Yen to purchase other currencies...and instead began buying Yen....that would cause the currency to appreciate...making Japanese exports less competitive globally.
On the other hand, currencies that have been on the other end of the carry trade...and have therefore unfairly been overly appreciated as a result...could see their currencies depreciate as a result of the "unwinding" of the carry trade...making their exports more competitive in the global markets.
It is by this mechanism that we see the linkage between the US credit crisis and global markets. The credit crisis causes a sharp increase in "risk aversion", which leads investors to abandon the "carry trade", which has a sharp impact on global currency markets, which effects the comparative advantages of companies all over the globe, from Japan to Brazil to Turkey...etc...
An interesting conclusion: in response to the credit crisis, the export economies of countries such as Brazil might actually become more competitive in global markets.
How to invest:
Purchase Foreign Fixed income bonds
Trend: Finally seeing Japanese households willing to take more risk, and invest some of the $7.5 trillion overseas. According to the NY Times, " The market for uridashi bonds - foreign currency debt sold directly to wealthy Japanese individuals, many of whom are unimpressed with low yields at home - is growing at the fastest pace ever as investors seek higher returns and diversified portfolios."
Why do Japanese invest overseas?
Japan is undergoing a broad shift to increased risk appetite among household investors that is steadily chipping away at the total of about ¥780 trillion, or $7.2 trillion, in cash and bank deposits that yield very little at home. Household investors have been stuck with interest rates near zero for more than a decade, a vestige of Japan's efforts to escape deflation and the bursting bubbles in stock and real estate markets in the early 1990s
Where do Japanese invest?:
The South African rand highlights this shift: A combination of high interest rates, rich national resources and publicity around the upcoming 2010 football World Cup has pushed rand bonds to stardom in Japan. The rand has accounted for 22 percent, or $2.7 billion, of new uridashi issues this year compared with 13 percent in 2007, and its success has spawned a boom in uridashis offered in other exotic currencies. Sales of bonds in the Brazilian real and the Turkish lira, which now offer coupons of 10 percent to 15 percent, have also been on the rise. Australian and kiwi, or New Zealand, bonds still dominate with market shares of 42 percent and 35 percent, respectively.
Australian and New Zealand bonds often feature coupons of around 6 percent, well above typical Japanese yen bonds offering 1 percent to 2 percent, but substantially below what the new stars have to offer.
Effect on Japanese Yen (depreciation)
This persistent quest for better returns has been a main factor keeping the yen near a two-decade low on an inflation-adjusted, trade-weighted basis.
US dollar as a carry trade? YES!
What does Iceland's decision to raise its key interest rate to 15% yesterday have to do with the strength of the greenback? Plenty, according to currency experts. As other countries strengthen their currencies, the Federal Reserve has been loosening its monetary policy, creating a yawning gap between the yields on the dollar versus other currencies. Investors are taking advantage of this differential, selling dollars and buying higher-yielding currencies, a strategy known as a "carry trade."
In a carry trade, a trader borrows dollars from a bank, converts the funds into Icelandic krona, for example, and buys an Icelandic bond for the equivalent amount. If the bond is paying 15%, and the American interest rate is just 2.25%, the trader can make a profit off this differential, a whopping 12.75 percentage points.
Traditionally, the Japanese yen has been the currency of choice for a carry trade because the interest rate is close to zero. But as the Japanese currency has been strengthening, and the Federal Reserve continues to slash rates, investors are now looking at the dollar as a replacement currency. "It is pretty pathetic that the world's reserve currency is now being used as the carry trade currency," an investment strategist at Miller Tabac + Co., Peter Boockvar, said.
Risk
While the dollar as the currency for a carry trade makes sense, experts caution the strategy comes with risk, namely volatility. To accomplish a carry trade, traders borrow large amounts of the lower-yielding currency, like the dollar, to buy bonds denominated in a higher-yielding currency. If the dollar were to suddenly strengthen, for example, traders who must pay back the banks from which they borrowed the dollars may find it more costly than the yield differential they were generating from the carry trade.
"For the carry bet to really work, the market cannot be so volatile," a partner at Foreign Exchange Analytics, David Gilmore, said. "If we go back to a world of relative calm and benign risk, then yes, I can see the dollar becoming a funding currency for the carry trade, but at this point I don't think there is much chance of that happening." Another challenge for a dollar-denominated carry trade is the fact that banks are extremely risk averse in the current environment and may not be willing to lend to traders hoping to execute this kind of strategy. "We are in the midst of a crisis in the financial markets where we have whole markets drying up," a senior economist at Moodys.com, Tu Packard, said. "Banks are very risk averse right now and are looking more carefully to whom they are lending, making it very hard for traders to borrow the money to execute a carry trade."
Investing anyways
Still, foreign exchange traders say there are some taking the plunge. "The dollar is now lower than the Swiss frank and many other currencies, therefore there is a big fundamental shift causing investors to borrow dollars and invest in higher-yielding assets abroad," a trader and author of a book on foreign exchange trading, Abe Cofnas, said.
source: http://www2.nysun.com/article/73644
News
On Friday, Feb. 24, 2006 the Daily Telegraph published a blunt admission that the entire global financial system is on the verge of disintegration, as the result of the imminent collapse of the yen carry trade. Ambrose Evans-Pritchard penned the Telegraph story, "Global Credit Ocean Dries Up," and quoted from a number of leading financial analysts, who warned that the entire system is jeopardized if Japan goes ahead and raises interest rates, thus shutting down the yen carry trade, which has fueled global hyperinflation and speculative bubbles for the past several years.
As the Telegraph defined it, "The 'carry trade'—as it is known—is a near limitless cash machine for banks and hedge funds. They can borrow at near zero interest rates in Japan, or 1 pc in Switzerland, to relend anywhere in the world that offers higher yields, whether Argentine notes or US mortgage securities." Last week a crisis was triggered when the Fitch rating agency downgraded Iceland's sovereign debt. Interest rates in Iceland are 10.75 pc. The Bank of Japan has announced plans to abandon the zero interest rate policy, as early as next month. This has triggered the panic, cited by Evans-Pritchard.
Evans-Pritchard quoted a number of analysts. David Bloom of HSBC warned, "The carry trade has pervaded every single instrument imaginable, credit spreads, bond spreads; everything is poisoned. It's going to come to an end later this year and it's going to be ugly, even if we haven't reached the shake-out just yet. People have a Panglossian belief in the march of global capitalism but that will change as soon as attention switches back to US financial imbalances."
Stephen Lewis of Monument Securities was quoted: "There are several hundred billion dollars of positions in the carry trade that will be unwound as soon as they become unprofitable. When the Bank of Japan starts tightening we may see some spectacular effects. The world has never been through this before, so there is a high risk of mistakes."
Stephen Roach, chief economist at Morgan Stanley, was even more blunt: "The lure of the carry trade is so compelling, it creates artificial demand for 'carryable' assets that has the potential to turn normal asset price appreciation into bubble-like proportions. History tells us that carry trades end when central bank tightening cycle begins."
Political economist Lyndon LaRouche was far more plain-spoken and blunt. "The yen carry trade is in big trouble. The mere fact that such questions as those reported in the Daily Telegraph are being raised means that the carry trade is about to bite the dust. Iceland and other countries are going to go bankrupt. But the multiplier effect of the blowout of the carry trade is going to mean that the crisis hits with a magnitude far beyond any individual nation or currency. This will bring down the whole post-Bretton Woods floating exchange rate system."
More news:
Feb 28,2006
Iceland was running a large current-acccount deficit. But Iceland's current-account deficit, as Brad knows full well, was no more the cause of the krona's fall than the Fitch downgrade was. The point is that currencies which benefit from the carry trade are always going to be in a precarious position, because there's no hotter money than the money which is sitting in overnight bank accounts run by traders with hair-trigger reflexes.
Here's how it works: hedge funds, and prop desks, borrow money at something less than 5%, and then buy the Icelandic krona, which yields something more than 10% thanks to the central bank desperately trying to cool down an overheating economy. It's a great trade, unless and until there's a sudden fall in the krona, which can – and did – wipe out a year's worth of carry in a day and a half.
Where does this leave Brazil? I still think the Brazilian carry trade is a no-brainer. It doesn't even really matter where you're borrowing: it can be in yen at 0%, or in Swiss francs at 1%, or in euros at 2.25%, or in dollars at 4.5%. The only number worth concentrating on is where you're investing: in Brazilian reais at 17%. No credit rating agency is going to downgrade Brazil any time soon, I can assure you. And Brazil doesn't have a current-account deficit, so there's no "natural" downward pressure on the currency. Yes, there's an election this year, which can cause volatility, but the worst-case scenario, as far as the markets are concerned, is the status quo of a continuation Lula government.
The krona collapse spilled over into Brazil (now there's a textbook example of contagion for you) not because traders were worried about Brazil being next, but because they'd made so much money in Brazil that they needed to cash out some of their positions there in order to cover losses in Iceland. Smart investors will have treated the Icelandic affair as a fantastic Brazilian buying opportunity.
My feeling is that the good times will come to an end in Brazil, as good times always will. But it won't be because of a collapse in the value of the Brazilian real, so much as it will be due to a slow decrease in Brazilian interest rates, combined with a slow increase in interest rates in the rest of the world. For the time being, however, if I had any money to invest, I'd put it in Brazilian reais.
source: http://www.felixsalmon.com/000389.html
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High-yielding currencies advanced and low-yielding currencies suffered on Thursday as investors showed an increasing inclination to embrace risk.
Following the rise in January’s US retail sales revealed on Wednesday, analysts said news that Japan’s economy grew 0.9 per cent in the fourth quarter soothed fears over the global economy.
Neil Mellor, at Bank of New York Mellon, said: “Together, these reports have fuelled hope that the world’s two largest economies may yet avoid a technical recession, and investors have certainly been quick to capitalise.”
The news lifted Asian equities, boosting risk appetite and pushing investors back into carry trades, in which low-yielding currencies are sold to finance the purchase of riskier, higher-yielding assets elsewhere.
The Australian dollar was the star performer among high-yielding currencies. The Aussie was given a boost by an expectation-beating employment report that made it more likely that Australian interest rates were set to rise. Australia added 26,800 jobs in January, exceeding expectations for a rise of 15,000 and taking unemployment to its lowest level in more than 33 years.
David Woo at Barclays Capital said the data sealed the deal on a 25 basis point rate rise to 7.25 per cent when the Reserve Bank of Australia has its policy meeting in March. “It also raises the chances of a follow up rate hike,” he said.
By midday in New York, the Australian dollar rose 0.8 per cent to $0.9032 against the dollar and climbed 0.6 per cent to Y97.57 against the yen.
Meanwhile, the low-yielding yen came under pressure, easing 0.1 per cent to Y158.00 against the euro, dropping 0.6 per cent to Y213.85 against the pound and losing 0.6 per cent to Y85.41 against the New Zealand dollar.
Hans Redeker at BNP Paribas said equity markets were set to rebound and he was abandoning currency trades that benefited from risk aversion. He expected low-yielding currencies to come under pressure and the dollar to lose some value – except against the yen.
Mr Redeker said the “sea change” had not only been provoked by the data, but by signs of significant capital injections into the financial industry. This was fuelled by reports that the Government of Singapore Investment Corp was investing $2bn-$3bn in a fund set up to invest in troubled financial institutions. “We suggest long positions in euro/dollar, dollar/yen and euro/yen.”
The dollar eased 0.3 per cent to Y108.00 against the yen, however, after Ben Bernanke, chairman of the Federal Reserve, heightened the prospects of further cuts in US interest rates.
The dollar also fell 0.4 per cent to $1.4630 against the euro and dropped 0.5 per cent to $1.9725 against the pound.
Older news
source: economist.com 2-10-07
At its simplest this involves borrowing in yen at very low interest rates to buy higher-yielding assets, such as American or Australian bonds, or even emerging-market debt that offers a still more lucrative interest margin. Carry trades weaken the Japanese currency, because investors sell the borrowed yen to convert them into other currencies.
Carry trades make sense only if the investor assumes that the yen will remain weak. If it appreciated, this would increase the repayment cost of yen-borrowing and offset the interest differential. But such an assumption is dangerous when the yen is already so undervalued. In theory, carry trades should not yield a predictable profit because the difference in interest rates between two countries should equal the rate at which investors expect the low-interest-rate currency, here the yen, to rise against the high-interest-rate one. But the carry trade turns this logic upside down by causing the yen to fall, not rise. This, in turn, lures more investors into the same strategy, amplifying the distortion. Mr Paulson may be revealing more than he intends when he says the yen is “market-driven”: the market is chasing its own tail in defiance of the economic fundamentals.
An elusive number
Nobody really knows how big the carry trade is. Japanese official figures show little evidence of large net lending to foreigners. For much of 2006 Japan actually had a net inflow of bond investment. Estimates based on the short-term net foreign lending of Japanese banks put the carry trade at only $200 billion.
But hedge funds do not need to borrow yen and then buy higher-yielding currencies. Instead, the carry trade is typically done through transactions, such as currency forward swaps, that are off-balance-sheet and therefore do not show up in official statistics. A better clue comes from record net “short” positions in yen futures on the Chicago Mercantile Exchange. Estimates of the total size of the carry trade range as high as $1 trillion.
The term “carry trade” usually refers to leveraged trades by speculative international investors, such as hedge funds. But Japanese households have also shifted money out of their low-interest-rate bank accounts to earn a higher return in, say, New Zealand bonds. These outflows are certainly large, but they are of a very different nature. If markets suddenly become more volatile, hedge funds can very quickly unwind their short yen positions, whereas households are more likely to sit tight. It is the volatile type of trade that central bankers lose sleep over.
The received wisdom in the markets is that yen carry trades will continue as long as the BoJ raises rates only slowly. It would take a rise in Japanese interest rates of at least two percentage points to undermine these trades, and nobody thinks that likely in the next year or so. Furthermore, goes the argument, as long as interest rates stay low, so will the yen.
In fact, the main trigger for an unwinding of carry trades is likely to be not Japanese interest rates, but an upsurge in currency volatility. That is what happened in 1998, when enormous yen carry trades had built up. After Russia's default in August and the subsequent near collapse of Long-Term Capital Management, hedge funds reduced their leveraged positions and the yen started to rise. Then in October the Japanese government announced a plan to recapitalise its crippled banks, which further bolstered the currency, forcing those who had bet against it to cover their positions. The yen jumped by 13% within three days.
Nouriel Roubini, at Roubini Global Economics, says that the lesson of 1998 is that it takes only a small piece of positive news to unravel such trades. Suppose there is suddenly some good news about the Japanese economy at the same time as America's appears to be stalling. An initial rise in the yen could cause today's carry trades to unwind just as rapidly, causing the currency to soar, American interest rates to rise and risk spreads to widen. The volume of yen-related leverage is probably greater now than in 1998.
The G7 should be concerned about carry trades not just because they could suddenly unwind and trigger financial turmoil but also because the yen's misalignment is distorting the world economy. The yen carry trade has amplified global liquidity (see page 90), further inflating asset-price bubbles across the world. The trade has also prolonged global imbalances by making it easier for countries such as America, Britain and Australia to finance their large current-account deficits.
A severely misaligned exchange rate calls for action. It is true, as Mr Paulson says, that Japan is not intervening to hold down the yen. But since Japan still holds almost $900 billion of foreign-exchange reserves, accumulated a few years ago when it was intervening, it is hard to claim that the currency is truly market-determined. Stephen Jen, an economist at Morgan Stanley, argues that Japan's Ministry of Finance should consider selling some of those reserves to break the one-way bet against the yen. There is a risk that such a move could itself upset financial markets. But the lower the yen slides, the greater the threat of an even sharper rebound.
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