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There is much new lingo in the investing world as of late, such as LIBOR, the Baltic Dry Index, and “carry trades”. The carry trade is getting some serious play in the media so I thought I would give a very basic explanation of what it is, and why it may be playing a very large role in the “global de-leveraging” (another new buzz phrase) that we are experiencing now.
The Yen Carry Trade
A carry trade is, at the very elementary level, shorting a currency in which the native country has low interest rates and using the proceeds to purchase currency in a country that has higher interest rates. So long as there are no changes in the exchange rate, your rate of return is very close to the differential in interest rates. Example: If you sell 100 Japanese Yen and pay interest of 0.5% in Japan, you could take that 100 Yen and convert it to $1 Canadian Dollar (not the actual exchange rate, just an example). You can take that $1 Canadian Dollar and buy a Canadian Government Bond that pays 3%. Your rate of return is 3% less 0.5% which equals 2.5%.
Levering Up The Carry Trade
Here’s where the leverage comes into play. Forex and CFD brokers can allow for hideous amounts of leverage – I’ve seen factors as high as 200:1. If we take a *cough, cough* “conservative” leverage factor of 10, essentially you can earn 25% on the above carry trade example on your original principal.
Supply and Demand
Here’s another factor. The Yen Carry Trade is well practiced, there are trillions of dollars wound up in it, and all the shorting pressure on the Yen served to depress the Yen – which was even better for carry traders since when they received their interest and principal repayments from the other currencies and then converted them back to Yen to pay off their short positions, they made money on the conversion since the Yen had weakened. The money being made on the Yen Carry Trade was hideous.
Normally, if someone were to try and execute a carry trade, the theory of uncovered interest rate parity would dictate that the differential in interest rates signalled the direction in change of the currencies – such that no money should be made by executing a carry trade – kind of like a self-correcting arbitrage mechanism. However, the tremendous short positions required to initiate the Yen carry trade worked to throw this in reverse, keeping the Yen depressed and further fuelling the fire.
The Yen has been exceptionally strong as of late and this may have caused a massive unwinding of the Yen Carry Trade all at once. This entails de-leveraging and short covering which further exacerbates the rapidity of the unwinding, since short covering drives up the Yen. It has been estimated that there is over three times as much money tied up in the Yen Carry Trade as there is value in all the known oil reserves in the world. Now that is truly scary. The rise in the value of the Yen is near the top of the list of concerns for the G-7 nations who only this week issued a statement singling out the Japanese currency and it’s role in the current global economic crisis.