A few months ago I wrote this article about how shoppers in Tokyo using social networking are adding to deflation in Japan. In that article I mentioned the carry trade, which prompted a recent reader to write in asking what the carry trade is, and why it moves the yen. In this post, I’d like to only deal with the carry trade itself, and deal with how it affects exchange rates in a future post.
To clarify, a carry trade could involve and move any currency: it is basically borrowing a low yielding currency to buy and invest in a higher yielding currency.
For this post let’s use the Japanese yen and the Canadian dollar.
A few years back, for example, a high yield savings account in Canada may have yielded 4% interest per year. At the same time, someone could take out a loan in Japan for about 1.5% interest per year.
Therefore, (simply put) an investor interested in the carry trade could have taken out a loan in Japan on which he or she would have to pay 1.5% interest, transfer the money into Canadian dollars, drop it into a Canadian bank account and receive 4%: a profit of 2.5% per year.
More likely, however, he or she would have bought Canadian government or corporate bonds yielding much higher.
Of course, the exchange rate is highly linked to how much profit our investor would have made. If the Japanese yen appreciated during the year, it would have eaten into the profit made by the investor.
For example, let’s say an investor takes out a 10,000 yen loan at 1.5% to invest in Canada. When the investor exchanges the money the rate is 100 yen per $1 CAD (ie, she gets $100 CAD for the 10,000 yen). She puts her money in an account yielding 4%.
After one year she has paid 150 yen in interest and the Canadian bank account has $104 in it (for the sake of this example we are assuming a one time interest payment at the end of the year.) That is static. But there are three possible scenarios if the investor brings the money back to Japan:
1. The exchange rate hasn’t changed: In this case, the investor moves the money back and receives 10,400 yen. She has paid 150 yen in interest, so has made 250 yen on the transaction.
2. The yen has fallen compared to the dollar: In this case, our investor ends up making extra profit, as moving the money back results in more yen. Let’s say the exchange rate is now 110 yen per $1 CAD – moving $104 back to Japan will give her 11,440 yen. Minus her 150 yen interest, and she is left with a profit of 1290 yen.
3. The yen has appreciated compared to the dollar: This is the worst case for our investor, as she may lose money on the transaction if the yen has appreciated too much. If the yen has strengthened to the dollar, her Canadian dollars will buy less yen. Let’s say the exchange rate is now 90 yen per $1 CAD. In this case her $104 Canadian will only result in 9360 yen. Minus the 150 yen that she paid in interest for the loan, and she is at a loss of 510 yen.
The above are extreme examples, but it illustrates that the carry trade is very much dependant on interest and exchange rates. It can also be dangerous to your financial wellbeing.
However, investors involved in the carry trade look for currencies that tend to be stable and/or that trade in a band. (Until about 2005, for example, the Japanese yen and the American dollar traded in a band of 114 to 117… meaning the Bank of Japan made sure that it never moved outside of that range. It was the Golden Age of carry trade perhaps?)
As a final note, I will say that our bank account example is only that: an example. In reality, the act of taking one currency to invest in another is a carry trade. If I sell my Canadian dollars, buy U.S. dollars, and then buy an American stock, I am involved in the carry trade.
All in all, it is very simple on one hand, and very complex on the other, as it deals with various rates and uncertainties. If done properly though, as many Japanese did for a number of years, it can be very profitable. The problem arises when exchange rates fluctuate, panic sets in, and the carry trade adds to the turmoil.
But we’ll leave that for another post.