by Vicki Schmelzer
Many people are confused about what “carry trade” means and does not mean. Financial analysts talk endlessly about “the carry trade” and it is often difficult to figure out which carry trade they are talking about.
A carry trade is typically a medium to long-term position, not a day trade.
Fixed Income Carry Trades
In fixed income, a trader might buy a long-term bond (10 to 30 years in duration) in a given country, i.e., lend money at, for example, 4.0% and then offset this with a short-term note in the same country. The trader might hedge this position on a daily basis, which in a near-zero interest rate environment for an overnight rate, could mean nearly a 4% return over time. Or the trader might sell a five-year bond (effectively borrowing money) at say 2.5% and then in 5 years sell another five year bond at 2.0%, resulting in a 1.75% return. There are endless permutations of this trade.
Another way of doing a fixed income carry trade is to buy a long-term bond in a high yielding country and sell a long-term (or short-term) fixed income instrument in a lower yielding country. This trade has foreign exchange risk, which could be hedged to end up with a pure fixed income play. Some traders have a view on currencies and prefer not to hedge any spot exposure.
Say, 10-year Brazilian interest rates are 12% and Swiss franc interest rates are at 1.0%. A US based trader might sell $10 million versus the Brazilian real at 2.4000 for BRL 24,000,000 and at the same time buy $10 million versus the Swiss franc at CHF 0.9000 for CHF 9 million – both deals in the spot market. In effect, the trader is lending the BRL 24 million out at 12% (by buying a Brazilian bond) and borrowing CHF 9 million at 1% (by selling a Swiss bond). In a very simplistic world, if the FX market did not move, this trader would make roughly a 11% return, minus costs (brokerage/platform fees).
Forex Carry Trades
A pure currency carry trade play is when a trader decides to sell a low-yielding currency and buy a high-yielding currency, funding position on a daily or weekly basis, ideally picking up the interest rate spread. The lower yielding currency is called the “funding currency.” The trader then effectively “borrows” (via the forward points) the low-yielding currency each day (or week or whatever time period the trader chooses) and effectively “lends” (via the forward points) the high-yielding currency. In an environment where the low-yielding currency’s yields keeps moving lower or the high-yielding currency’s yields keeps moving higher, funding this position on a daily basis is an easy way to make a profit.
It is August 2007 and the United States federal funds rate is 5.25%. The South African Rand’s SABOR rate is around 9.60%. Assume that the interest rates are about the same from day to day. If you sell US dollars and buy the South African rand in the spot market, you will make money on the forward points by rolling the position one day forward (from spot to the next day or spot-next or from tomorrow to the next day or tom-next). Remember, forward points for currencies are based on a formula that includes the spot rate, the interest rate differential, and the time period.
By August 2008, the fed funds rate has fallen to 2.0% and the SABOR rate has risen to about 11.70%. With a USD/ZAR short position, a trader would have made even more profit than initially expected, with the interest rate spread widening from 4.35% to 9.70%. This is true only if the spot currency rate did not move. Depending on whether the spot USD/ZAR rate went up or down, the trader would have an additional profit or a loss. In this example, USD/ZAR rose from about ZAR 7.3900 to ZAR 7.8700 (mid-August 2007 to mid-August 2008), so the trader would have lost 6.5% on the spot position. In this instance, it does not fully erase the profit made on the daily rollover, but there are times when it can.
Pro tip: Carry trades are best utilized when overall volatility is low and interest rate differentials are expected to stay relatively stable.
Historically, the classic funding currency for Forex carry trades was the Japanese yen. During the 1980’s, speculators took advantage of ultra-low Japanese rates to borrow in yen and invest in European and other securities. The USD/JPY fell from 277.65 in November 1982 to 79.70 in April 1995, so carry-traders had to pay back borrowed yen at a higher Forex rate — but for many, it was worth it, anyway.
Another round of yen carry trades began in the summer of 1995 and ended in late 1998 — during the Asian financial crisis. The currency crisis that started in Thailand spread to Argentina and Russia. Russia defaulted, triggering the failure of the US hedge fund Long-Term Capital Management. The Japanese government had to re-organize and re-capitalize the distressed banking sector — but rates remained low. The USD/JPY rose from 81.77 in May 1995 to 146.75 in June 1998.
It is an amusing footnote that quite often Forex commentators attribute carry trades or the unwinding of carry trades to moves in the yen that they cannot otherwise explain. The probability is very low that these commentators know for a fact that the carry trade is behind the move because we do not get hard information on carry trades from any source. But it is a dandy excuse.
After the US financial crisis began to heat up after Lehman Brother’s bankruptcy in mid-September 2008, the Federal Reserve began to lower interest rates and the dollar, up until then rarely used as a funding currency, soon found itself in that role. With the Fed expected to keep rates low for longer, traders were happy to be short dollars and long higher yielding currencies such as the Mexican peso or Aussie dollar. Another example of a low-yielding currency often used in recent years as a funding currency for an FX carry trade is the Swiss franc.