Carry Trade

Definition

A carry trade is a trade that profits from the spread between borrowing a low-carry (low-yield) asset or currency and lending in, or investing in, a high-carry (high-yield) one. Unmodified, "carry trade" means the currency carry trade: investors borrow low-yielding currencies and lend in high-yielding currencies. It is an uncovered interest arbitrage, not necessarily a true arbitrage, because it turns a profit only if nothing moves against it. In this borrowing context, positive carry means the held asset's yield exceeds the borrowing rate, and negative carry means it is lower.

Korean-language sources also describe 차입 거래 as the strategy of borrowing money to buy and hold financial assets and later selling them for the difference, a broader usage than the currency carry trade.

History

Carry trades are difficult to track in available data. In recent years, however, interest rate differentials have been a driving force behind exchange-rate movements, focusing market attention on currency carry trade positions and the possibility that a sudden unwinding could adversely affect financial stability.

Since the mid-1990s the Bank of Japan set Japanese interest rates at very low levels, making it profitable to borrow yen to fund activities in other currencies, including US subprime lending and emerging-market funding, especially in the BRIC countries and resource-rich economies. By early 2007 an estimated US$1 trillion may have been staked on the yen carry trade, and the trade largely collapsed in 2008, particularly in regard to the yen.

The US dollar and the Japanese yen have been the currencies most heavily used in carry trade transactions since the 1990s. When a currency appreciates, pressure arises to cover debts in it by converting foreign assets, which can accelerate valuation changes and trigger a carry reversal. The timing of the 2008 carry reversal contributed substantially to the credit crunch behind the 2008 financial crisis, though the relative size of the carry trade's impact versus other factors is debatable.

Examples

The yen carry trade is the representative case: borrowing yen cheaply to buy assets in higher-yielding countries' currencies, with losses possible if the exchange rate is higher when repaying than when borrowing.

The 2008–2011 Icelandic financial crisis has among its origins undisciplined use of the carry trade, notably Euro-denominated loans to buy homes and other assets within Iceland. Most such loans defaulted when the Icelandic currency depreciated dramatically, making loan payments unaffordable. Within Japan, the collapse of the carry trade in 2008 is often blamed for rapid yen appreciation.

Relations

Carry trades are thought to correlate with global financial and exchange-rate stability and to retract during global liquidity shortages, but they are often blamed for rapid currency value collapse and appreciation. They are also linked to maturity transformation, the interest-rate-differential carry trade commonly practised by commercial banks, which borrow cheap short-term and lend at higher long-term rates. That trade loses money when the yield curve inverts and has contributed to bank failures.

According to uncovered interest rate parity, carry trades should not yield predictable profit, because the interest-rate difference between two countries should equal the expected rate at which the low-interest-rate currency rises against the high-interest-rate one. Nonetheless carry trades weaken the borrowed currency, because investors sell it to convert into another currency. The carry trade is thus a strategy premised on deviations from uncovered interest parity.

Distinctions

A carry trade is not necessarily an arbitrage: a true arbitrage must be risk-free, while carry trades profit only if nothing changes against the carry. The term without modification denotes the currency carry trade specifically, distinguishing it from the broader "carry" concept, the return from holding an asset or its cost if negative. Unlike covered interest arbitrage, in which the exchange-rate risk is hedged, a currency carry trade is uncovered interest arbitrage: investors choose not to hedge, so returns depend on how the exchange rate between the currency pair actually develops. Appropriately hedged positions, by contrast, can be positive carry where the forward or futures market pays sufficient premium.