The carry trade Ã¢â‚¬â€œ a phenomenon of the forex markets where traders short low-yielding currencies in favor of higher-yielding currencies Ã¢â‚¬â€œ seemed to be pretty much left for dead as Central Banks adopted zero-bound interest rates and a policy of quantitative easing to deal with the on-going economic crisis. The only countries that continue to offer high interest rates belong to the developing and emerging class that because of their inherent greater risks, are forced to offer premiums to attract investment.
The forex carry trade is based on the fact that traders must pay interest on the money they borrow, while receiving interest on the currency they buy. Naturally, interest rates vary depending on the currency, so traders strive to borrow a currency that requires them to pay as little as possible, while holding a currency that pays considerably more. The difference between the two rates is known as carry which, if positive, the trader gets to keep as profit. As long as exchange rates remain stable and the interest rate differential remains in the traderÃ¢â‚¬â„¢s favor, carry trades represent very little risk to the investor.
For much of the past thirty years, carry traders have borrowed (shorted) yen in order to acquire more capital which is then used to buy (go long)and hold higher-yielding currencies historically consisting of the Australian and New Zealand dollars. Since the early 1990s, Japan has maintained a benchmark lending rate in the 1 percent range while Australia and New Zealand have seen interest rates fluctuating between 5 and 7 percent for most of this time making these pairs the most popular carry trades. Starting earlier last year however, Central Banks began to seriously lower interest rates in an attempt to fight deflation and this has minimized the profit potential of carry trades and forced many investors to abandon altogether the carry trade in favor of another strategy.
Despite the narrowing of interest rates in the traditional carry trade currencies, investors appear to be turning once again to the carry trade as a viable trading regimen. Goldman Sachs even released a report last week titled Ã¢â‚¬Å“Time to Reconsider CarryÃ¢â‚¬Â in which analysts report that they believe Ã¢â‚¬Å“conditions are about to fall in place to make carry strategies attractive againÃ¢â‚¬Â.
Unlike the yen-based carry trade of yore, the currencies offering higher yields today are of the more, shall we say, exotic variety and include the Turkish lira, the Brazilian real, South African rand, and Hungarian forint. These currencies offer higher yields because they also carry much higher risk and despite how attractive TurkeyÃ¢â‚¬â„¢s overnight lending rate of 11.5 percent may appear to an investor holding US dollars earning next to nothing at the moment, it would still take a brave soul indeed to sell off a large investment of dollars to hold lira exclusively. This explains the renewed attention being paid to investment firms offering units in a basket of high-yielding / high-risk currencies.
By offering a basket of these currencies, risk can be spread the risk across multiple currencies so policies or events in one country leading to a devaluation of that countryÃ¢â‚¬â„¢s currency, have a limited effect on the overall basket. Nevertheless, the fact that these currencies offer much greater returns should be a clear warning as to their overall volatility so it will be interesting to see how much investment capital they can attract at a time when investor appetite for risk is still very low.
About the Author
Scott Boyd has been working in and writing about the financial industry since the early 1990s. As a technical writer and project manager with several of Canada’s leading financial institutions, Scott has produced educational materials for investment system end-users including portfolio managers and traders. Scott now administers and contributes to OANDA FXPedia and regularly provides commentaries for the OANDA FXTrade website.