THE leveraged carry trade strategy is one of the favorite trading strategies of global macro hedge funds and investment banks. It is the quintessential global macro trade. In a nutshell, the carry trade strategy entails going long or buying a high-
yielding currency and selling or shorting a low-yielding currency. Aggressive speculators will leave the exchange rate exposure unhedged, which means that the speculator is betting that the high-yielding currency is going to appreciate in addition to earning the interest rate differential between the two currencies. For those who hedge the exchange rate exposure, although interest rate differentials tend to be rather small, on the scale of 1 to 5 percent, if traders factor in 5 to 10 times leverage, the profits from interest rates alone can be substantial. Just think about it: A 2.5 percent interest rate differential becomes 25 percent on 10 times leverage. Leverage can also be very risky if not managed properly because it can exacerbate losses. Capital appreciation generally occurs when a number of traders see this same opportunity and also pile info the trade, which ends up rallying the currency pair.
In foreign exchange trading, the carry trade is an easy way to take advantage of this basic economic principle that money is constantly flowing in and out of different markets, driven by the economic law of supply and demand: markets that offer the highest returns on investment will in general attract the most capital. Countries are no different in the world of international capital flows, nations that offer the highest interest rates will generally attract the most investment and create the most demand for their currencies. A very popular trading strategy, the carry trade is simple to master. If done correctly, it can earn a high return without an investor taking on a lot of risk. However, carry trades do come with some risk. The chances of loss are great if you do not understand how, why, and when carry trades work best.
How Do Carry Trades Work?
The way a carry trade works is to buy a currency that offers a high interest rate while selling a currency that offers a low interest rate. Carry trades are profitable because an investor is able to earn the difference in interest—or spread—between the two currencies.
An example: Assume that the Australian dollar offers an interest rate of 4.75 percent, while the Swiss franc offers an interest rate of 0.25 percent. To execute the carry trade, an investor buys the Australian dollar and sells the Swiss franc. In doing so, he or she can earn a profit of 4.50 percent (4.75 percent in interest earned minus 0.25 percent in interest paid), as long as the exchange rate between Australian dollars and Swiss francs does not change. This return is based on zero leverage. Five times leverage equals a 22.5 percent return on just the interest rate differential. To illustrate, take a look at the following example and Figure 9.5 to see how an investor would actually execute the carry trade:
Executing the Carry Tirade
Buy AUD and sell CHF (long AUD/CHF).
Long AUD position: investor earns 4.75 percent.
Short CHF position: investor pays 0.25 percent.
With spot rate held constant, profit is 4.50 percent, or 450 basis points.
If the currency pair also increased in value due to other traders identifying this opportunity, the carry trader would earn not only yield but also capital appreciation.
To summarize: A carry trade works by buying a currency that offers a high interest rate while selling a currency that offers a low interest rate.
Why Do Carry Trades Work?
Carry trades work because of the constant movement of capital into and out of countries. Interest rates are a big reason why some countries attract a great deal of investment as opposed to others. If a country’s economy is doing well (high growth, high productivity, low unemployment…
Figure 9.5 Leveraged Carry Trade Example
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…be able to pay high interest rates. Indeed, there is a clear chance that something might happen to prevent the country from paying this high interest rate.
Ultimately, the investor must be willing to take this chance.
If investors as a whole, were not willing to take on this risk, then capital would never move from one country to another, and the carry trade opportunity would not exist. Therefore, in order to work, carry trades require that investors as a group have low risk aversion, or are willing to take the risk of investing in the higher-interest- rate currency.
To summarize: Carry trades have the most profit potential during times when investors are willing to take the risk of investing in high-interest-paying currencies.
When Will Carry Trades Not Work?
So far we have shown that a curry trade will work best when investors have low risk aversion. What happens when investors have high risk aversion?
Carry trades are the least profitable when investors have high risk aversion.
When investors have high risk aversion, they are less willing as a group to take chances with their investments. Therefore, they would be less willing to invest in riskier currencies that offer higher interest rates. Instead, when investors have high risk aversion they would actually prefer to put their money in "safe haven" currencies that pay lower interest rates. This would be equivalent to doing the exact opposite of a carry trade—in other words, investors are buying the currency with the low interest rate and selling the currency with the high interest rate.
Going back to our earlier example, assume the investor suddenly feels uncomfortable holding a foreign currency, the Australian dollar. Now, instead of looking for the higher interest rate, she is more interested in keeping her investment sale. As a result, she swaps her Australian dollars for more familiar Swiss francs.
The net effect of millions of people doing this transaction is that capital flows out of Australia and into Switzerland as investors take their Australian dollar and trade them in for Swiss francs. Because, of this high investor risk aversion, Switzerland attracts more capital due to the safety its currency offers despite the lower interest rates. This inflow of capital increases the value of the Swiss franc (see Figure 9.7).
To summarize: Carry trades will he the least profitable during times when investors are unwilling to take the risk of investing in high-interest-paying currencies.
Figure 9.7 Effects of a Carry Trade When Investors Have High Risk Aversion:
AUD/CHF Carry Trade Example 2 Importance of Risk Aversion
Carry trades will generally be profitable when investors have low risk aversion, and unprofitable when investors have high risk aversion. Therefore, before placing a carry trade it is critical to be aware of the risk environment—whether investors as a whole have high or low risk aversion—and when it changes.
Increasing risk aversion is generally beneficial for low- interest-rate-paying currencies: Sometimes the mood of investors will change rapidly — investors’
willingness to make risky trades can change dramatically from one moment to the next. Often these large shifts are caused by significant global events. When investor risk aversion does rise quickly, the result is generally a large capital inflow into low- interest-rate-paying "safe haven" currencies (see Figure 9.6).
For example, in the summer of 1998 the Japanese yen appreciated against the dollar by over 20 percent in the span of two months, due mainly to the Russian debt crisis and Long-Term Capital Management hedge fund bailout. Similarly, just alter the September 11, 2001, terrorist attacks the Swiss franc rose by more than 7 percent against the dollar over a 10-day period.
These sharp movements in currency values often occur when risk aversion quickly changes from low to high. As a result, when risk aversion shifts in this way, a carry trade can just as quickly turn from being profitable to unprofitable. Conversely, as investor risk aversion goes from high to low, carry trades become more profitable, as detailed in Figure 9.8.
How do you know if investors as a whole have high or low risk aversion?
Unfortunately, it is difficult to measure investor risk aversion with a single number.
One way to get a broad idea of risk aversion levels is to look at the different yields that bonds pay. The wider the difference, or…
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Time Horizon In general, a carry trade is a long-term strategy. Before entering into a carry trade, an investor should be willing to commit to a time horizon or at least six months. This commitment helps to make sure that the trade will not be affected by the "noise" of shorter-term currency price movements. Also, not using excessive leverage for carry traders will allow traders to hold onto their positions longer and to better weather market fluctuations by not getting stopped out.
To summarize: Carry trade investors should be aware of factors such as currency appreciation, trade balances, and time horizon before placing a trade. Any or all of these factors can cause a seemingly profitable carry trade to become unprofitable,