What is the Carry Trade?

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.

Weekend Reading

Just a few of the interesting articles I have come across recently:

1. The past couple weeks in the world of Canadian blogging has seen a whirlwind of controversy surrounding the creators of a marketing website which claims to be able to introduce you to a strategy that can save you up to 100% of taxes. Interested parties should see Preet’s post (which has further links to the back story) and listen to his interview with one of the (as I see it) pawns for the Mastermind of this program.
2. Million Dollar Journey has a crash course in how living abroad affects your Canadian tax situation. As a Canadian living abroad, I disagree with some of the statements, but it is generally accurate.
3. Money Smarts has a great post about taking money OUT of an RESP. I am just about the enter the years where I put money IN to an RESP, but great to know for the future.
4. Canadian Capitalist reported that ING Direct will begin a no-fee chequing account in 2011. I think when we move back to Canada we will go with PC Financial, but it’s nice to know there are some other players.
5. I thought this post at Thicken My Wallet was great: it compares switching investment strategies to thinking you can be better at golf by buying a more expensive club.
6. Keeping with the sports motif, Andrew Hallam has a tennis analogy that looks at the track record of “great” fund managers vs. a basket of terrible stocks… 15 – love, it seems.
7. Canadian Finance Blog had a good post on marginal tax rates and how it relates to your RRSP.
8. The Financial Blogger says that investing in the U.S. now while the Canadian Dollar is high is something to consider. I agree, and have added to my U.S. holdings on money I exchanged at par or above.
9. Canadian Couch Potato cautions against putting your short-term cash into high-yield/high-risk funds. The last line killed me…actually, there were a few good ones in the post.
10. Provident Planning hosted the Carnival of Personal Finance this week. There is an amazingly long list of other great articles in that post, so drop by if you are looking for some further reading.

Hope everyone has a great week.

Spending Can Be Good

Generally speaking, the premise of this blog is to talk about ways to save, invest, and avoid wasting money, as well as to speak of topics specific to Canadians living abroad.

But let’s face it: we save money for the sake of enjoying it.

Anyone who forgets that is doomed to face either the three ghosts of Christmas Past, Present and Future, or the fate of Silas Marner, who built his fortune only to have it stolen away from him.

My wife and I are great savers. We enjoy earning cash and bookkeeping our income and outcome. But it is all with purpose.

We are approaching out 2-year anniversary, and as I only had a limited amount of time off this summer, we decided to celebrate a little early by taking a trip and some time for ourselves.

Some will remember that I made some re-posts a week or so back, and that is because we were off to a natural hot spa, enjoying the water of a volcanic country, as well as the various local foods that can be found throughout Japan.

A back of the envelope calculation tells me that we spent about $600 Canadian (including lodgings, food, transportation and gifts) for a one-night, two-day stay in a spa area about two and a half hours from where we live.

Do we regret any of if? … Not one single cent (yen).

Years ago I would have thought that a ridiculous amount of money to spend for 48 hours, but at this point in my life I think that – not only am I grateful for the fact that I have a business that allows me such occasional self-pampering, but also for the fact that I have such a great wife/partner/spouse to spend that money with.

I respect Warren Buffet immensely, but I remember reading about what he said when his wife spent a certain amount of money on new furnishings for their house (at the time a remarkable amount): he said something to the effect of “Do you know what that is compounded over 30 years?”

Fair enough. I could compound my $600 over several years and have a good amount of money. But I guarantee that it wouldn’t bring me the satisfaction that was brought by relaxing 48 hours with my wife, while enjoying several seismic baths,  great food and great atmosphere.

Remember: even Ebenezer Scrooge and Silas Marner were brought around to the beauty of humanity over money eventually.

Do It Yourself

My mother-in-law has slowly been growing a jungle leading up to her front door. Since it has been a slow progression, it hasn’t been something that has stood out. But recently, we’ve noticed its greatness – especially since my wife’s sister had a baby, and one must move away the plant-life to get the stroller past.

Earlier this month, my mother-in-law went on a trip to Korea. When my wife asked one day “What do you want to do today?” I quickly answered that I wanted to tame the jungle. We went over and I took about 30 minutes to clip the craziness that had grown over the walkway.

When my mother-in-law got back, we all went out, and she thanked me. She followed up by saying that she wanted to get rid of it all, and that she would get some landscaping company to come in and take care of it.

I told her not to make any calls because I was about to come into some vacation, and that I would take care of it.

When I started the job I quickly realized that it was more than I had planned for; the company that she hired to remodel her kitchen 2 years ago had left, not only the wooden pallets, but also her old counter-top. They had craftily slid that memorabilia between a shed and a stone wall. So I had to take care of the jungle, and, of course, the refuse of another company.

All-in-all, from start-to-finish, the job took me about six hours spread over four days. Her walkway is now remarkably wide (who knew) and free of anything resembling the Amazon, save for one nice hanging plant.

And finally I get to the financial part: Had I been swift, I would have called in a company for an estimate before starting. Since I didn’t, I have to ballpark on my own salary. Given my average hourly rate and the time spent, I would have received (if teaching) about $300.

I cut away all greenery, but as I had to take each pot one-by-one down the road to an empty lot to shake away the dirt, I will assume an extra $10 for disposal. I will minus $30 with the assumption that having a disposal vehicle would reduce the working time, and we are left with a (roundabout) number of $280.

So here’s the thing: my mother-in-law could have paid (let’s say) anywhere from the equivalent of $250 – $350 to make her walk way as beautiful and accessible as it is now, but instead, I was able to give some time and do it for her.

The totals?

I spent about $15 buying the following: work gloves, a hacksaw and blades (there was also a set of old blinds that I decided to deal with), a short handsaw, garbage bags, a few litres of iced tea.

And for doing all the work my mother-in-law took my wife and I out for dinner this past weekend. (My wife got the better deal by far, as she sat in front of a fan and cheered me for about 2 of the total 6 that I worked)

So what’s my point?

The point is simply this: if you can take care of things yourself, you should do so. I was able to save my mother-in-law (a guesstimate) of at least $150, and all she had to do was take us out for dinner (her suggestion). And I was able to get in some great exercise, a good sweat, and the satisfaction of a job well done.

Now, as I have realized that it is full of unnecessary things, all I have to deal with is the shed.

Welcome New Readers

Larry MacDonald at the Globe & Mail was kind enough to contact me a few weeks back to be interviewed for the Me and My Money investor profile in Saturday’s paper. The article can be found here.

Because of that I have seen a big jump in readers over the weekend. I’d like to say thank you for dropping by the blog.

I do not post everyday, but try to get about three per week. So rather than coming back only to find that there is no new content, readers new to In Search of Salt may like to select one of the “direct to you” options on the right. Click the orange button to add this blog to your favourite RSS reader, or subscribe to have article notifications sent to your email.

Again, thanks to Mr. MacDonald for the write-up, and thanks to you for taking the time to look through the blog.