Currency carry trade refers to the trade, where an investor borrows a currency from a country with a low interest rate, and then invests it in a country that yields a higher interest rate.
The Yen carry trade is the most popular example of the currency carry trade, because Japan has had low interest rates for a fairly long period now. Investors borrowed cheap Japanese Yen, and then bought securities like the US Treasury Bills, which gave them relatively higher interest rates. This type of thing worked really well when exchange rates were stable, and traders could leverage their investments to get great returns. But, the downside is that since two currencies are involved, fluctuations in exchange rates can kill all and any profits you make on your trade.
Here is an example of how this works:
Suppose 1 USD = 110 JPY. I borrow 110,000 JPY at 0.5%, and convert them into a $1,000. I then invest this in securities yielding 4.5%. So, at the end of the year, I get an interest of $45, and I have a total of $1045.
If the exchange rate doesnâ€™t move at all, at 0.5%, my interest comes out at 550 JPY. I take my $1045, and convert them to JPY at â€“ 1045 x 110 = 114,950. I pay off the 550 interest, and am still left with: 114,950 â€“ 550 = 114,400.
At the end of it, I make 114,400 â€“ 110,000 = 4,400 JPY, in a transaction where I didnâ€™t have to do anything, but borrow in one country and invest in another.
This is great till the time the exchange rate turns against you.
Suppose the exchange rate changed to 1 USD = 95 JPY. Then at the end of the year, you will still have $1045 with you, but that will just amount to: 1,045 x 95 = 99,275 JPY. You still need to pay an interest of 550 JPY, which means that you end up with 99,275 â€“ 550 = 98,725 JPY.
The exchange rate fluctuation killed whatever profit you could have made, and also ate into your principal.
Borrowing at half a percent and investing at 4.5% worked quite well during the boom. But, with the financial crisis at its peak, the Yen rose considerably because investors fled to safety, and the yen carry trade stopped being as talked about, as it used to be. For a long time I read virtually nothing on it, till I stumbled on this WSJ article today about carry trades gaining in currency again, because the markets are stabilizing.
WSJ reports that currency carry trades are starting to find their way into the Brazilian Real and the Australian Dollar because of their high yields and prospects of economic rebound.
It will be interesting to see if traders find any luck with such trades this time around, and this is probably one more sign that the effects of the financial crisis are abating, and things are getting back to the way they used to be.