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What is the Carry Trade?


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Besides penny stock trading, another growing form of investing in the Forex market is the carry trade. In short, an investor sells a currency with a low interest rate and uses the funds to purchase a second currency that carries a higher interest rate. By using this strategy and leveraging the trade, an investor can make a substantial return. The most often quoted carry trade strategy is the yen carry trade, in which Japanese Yen is the borrowed (or shorted) currency.

Historical background of the Yen Carry Trade

japanes yen carry tradeUnique conditions with the Japanese Yen became the impetus for a carry trade during the 1990’s. To understand why this became so, one needs to know some of the economic history of Japan. After WWII, Japan’s government implemented many tariffs and encouraged their people to save money and invest in domestic products. This policy lead to more money in Japan’s banks and it made loans and credit easier to obtain. Eventually this chain reaction effect caused Japan to run high trade surpluses and the cost of Japanese-produced goods were much lower than their competition overseas. Eventually this buildup of cash coupled with a deregulated financial industry caused asset prices to rise to exorbitant amounts. In 1989 the market peaked and a long decline followed called The Lost Decade in which the country experienced economic stagnation and deflationary pressures.

 

A Worldwide Carry Trade Emerges

the carry trade

During The Lost Decade in the 1990’s, the Bank of Japan decided to try new kinds of monetary policy in order to combat the kept interest rates as close to zero in order to encourage inflation and dissuade spending. By contrast the US had interest rates of around 5%. This allowed investors to borrow Japanese yen to buy US dollars. The interest rate differential was called a “carry”. Many large investment companies like Goldman Sachs were using this carry during the 90’s to help drive massive profits. This has continued into the 2000’s but has begun to shift as the world economy has changed.

Decline of the Traditional Yen Carry

One of the primary issues with the yen carry trade was that it depended on having a second currency with a high interest rate. In the 90’s the US dollar was around 5% but due to the world financial crisis in 2008 and the mortgage bubble in the US, the Federal Reserve began to adopt similar monetary policy to the Bank of Japan including holding interest rates near 0%. This has caused investors to look at other currencies such as the Australian Dollar, which currently holds an interest rate of 2.75%. Many utilizing carry trade strategy now utilize the low rate of the US dollar and the fact that it has been depreciating against most world currencies.

currency exchange dollar to yen

This is especially favorable to those borrowing USD as the amount needed to repay the loan is smaller and contrasts with the Japanese Yen which up until recently had been appreciating against almost every world currency.

Understanding the Risk Factor of the Carry Trade

As with all Forex trading, the primary risk/reward is defined on which direction the exchange rate moves and where your position is open. An issue in finding a good currency pair to utilize the carry is that the exchange rate moving is the risk. The currency exchange rate needs to be fairly stable and predictable in order not to risk losing far more than a carry differential will produce. Considering most traders will be utilizing leverage to maximize profits, this can also maximize losses if a pair moves against you.

Re-Emergence of a New Yen Carry?

While the global financial crisis signaled the end of an era in lucrative yen carry trading, there might be a new potential on the horizon. The Bank of Japan has again shifted monetary policy in order to end what it calls “endaka”, or “strong yen”. For Japan, it is detrimental to have a highly valuable Yen as their economy is strongly based on exports. A strong Yen causes the price of goods sold overseas to rise. Coincidentally it also harms the yen carry trade. In April 2013, the Bank of Japan decided to spend $1.4 trillion USD over 2 years to double its monetary base and combat endaka.

Is Utilizing the Carry Trade For You?

This brings us to the final point. Does it make sense for you to use the carry trade? It’s unlikely that we will see the high interest rate differentials of the 90’s with modern monetary policy. It’s also unwise to eschew traditional Forex trading basics. Coupling knowledge of how to use a carry will help to maximize your potential gains and act as icing on the cake when Forex trading.

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