In plain and simple terms, when you sell a currency with low interest rate and use the funds generated to buy another currency with high interest rates, you get to keep the difference between the interest rates.
In plain and simple terms, when you sell a currency with low interest rate and use the funds generated to buy another currency with high interest rates, you get to keep the difference between the interest rates.
Gains? Maybe, but there are no guarantees
You got it … the interest rate differential is the very basis of this trade opportunity. This also means that you are depending on the economy of the country that promises you to pay a higher interest rate. At the same time, you’d do well to realize that there are no guarantees in the practical world.
The Popular Lenders
Because of their low interest rates, the Japanese Yen and Swiss Franc are the two most favoured borrowing currencies in the carry-trading universe.
Where Should You Invest?
If you were trying to make a guess again, you may be thinking of US dollar to invest in (but you’d be considered a conservative among the carry traders if you do that). The other popular currencies are Australian and New Zealand dollar or even other emerging economy currencies that promise a higher interest rate. Of course, you need to be a little adventurous to do that.
Are There any Risk Factors?
Yes. Of course, there are risks, plenty of them … which trade doesn’t? But here the losses may be huge. The primary risk is the currency you’ve borrowed in appreciates thereby wiping the difference between low borrowing rate and high interest rates on your investments. There have been instances when the investors sold high return assets to repay their Yen debts since it was appreciating. The markets are also aware of these factors and readily take these into account while determining currency prices resulting in overreactions.
Then There are Risk Mitigating Factors as Well
The Yen, however, did not appreciate as much as was expected. The reason was that majority of the carry traders were Japanese and they sold Yen as its value appreciated thereby counteracting the foreign speculators’ Yen purchases. The traders expect the Japanese government to step in whenever its currency appreciates so that the Japanese exporters may remain protected.
The Usual Challenges
The three major currencies that tend to be overvalued due to carry trade are Australian and New Zealand dollars and GB Pound. In the event of a mild stirring in the currency-trading universe, these currencies may lose 5% of their value within a week. The factors that may trigger a downfall include Australian and New Zealand trade deficits and then there chinks in the UK’s armour too.
Last but not the Least
Much as it may go against the usual beliefs, the fact remains that the biggest profits in the carry trade come from the appreciation of the high yielding currency and not from the difference in the interest rates. Hence sell whenever the currency you’ve invested in gains in value. After this period is over, you are likely to lose money for some time to come (you’d not gain as much as you might have).
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Wright Investment Properties, Inc.
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Memphis, TN