Carry trade basics

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Carry trade basics

Let's say that the economy of Country A is stagnating, its maybe facing a deflationary crisis, so Central Bank tries to print as much money and lower interest rates as much as possible.

And an investor can go into Country A and borrow in A's currency at a 1% interest rate.

Lets also say that in the rest of the world, and in particular, in Country B, one can actually make relatively, or what you perceive as safe investments, at a higher interest rate in Country B's currency.

And so lets say that you can get a 5% return.

So you can imagine that some opportunistic investors might say "Wow I could borrow in Country A's currency" and so lets say they go into Country A.

They borrow at 1% and in particular they borrow 100, and I won't call them Dollar's or Yen, or Euros.

I'll call them 100 A's where the name of A's currency is an A.

So they borrow 100 A's and lets say the conversion rate, right now at this point in time, 1A = 2B's.

So they go into currency markets and they exchange it for every 1A they get 2B's.

So they exchange it for 200 B's, and then they go and invest it, they are investing in B's.

So they are borrowing in A's and they are investing in B's.

And so what would happen?

Well, they're going to get 5% on their money in B's, so 5% of 200, they're going to get 10 B's (lets say that's per year)

So they're going to get 10 B's in interest every year.

And then they can convert that.

They can convert those 10 B's, if we assume the exchange rate holds constant, and that is a big assumption.

They can convert that to 5A's based on the same exchange rate.

So that will be 5 A's, but they only have to pay 1A in interest, and so they're just going to get 4 A's per year, if we assume constant exchange rate, they're going to get 4 A's a year for free.

Assuming that they could continue to do this and then they could take those 4 A's and convert them to B's or whatever other currency they want.

So you could say they're getting 4 A's for free every year, or they're getting 8 B's per year every year.

And this little process, this trade, this little perceived arbitrage that's going on right over here, this is called the carry trade.

You might think, where would this break down?

Well the main area where this would break down is while you were borrowing in A, then investing in B, if A's currency appreciates, especially relative to B's currency,

because then what happens, even though you have this interest rate discrepancy and even though you feel like your getting 10 B's, those 10 B's are going to give you fewer and fewer A's if A keeps appreciating.

Or another way to think about it is, your going to in terms of B's, even though you think you only owe 1% interest A is also going to appreciate, so in terms of B's your going to owe more and more B's every year if A appreciates.

Now what's worked out in the carry trade or at least the most famous of the carry trades, where starting in the mid-90's,

people started borrowing in Japan because they had low interest and then investing other places, like the US, and especially other places like Iceland, is that the more people do this.

So you can imagine, if a lot of people keep doing this and it becomes kind of a big herd effect, what happens?

You have a bunch of people borrowing in A and then converting it to B.

So they're taking this currency and converting it to the magenta currency.

And if that happens, then you actually have the opposite effect.

Then you have a benefit on top of the interest rate discrepancy because that means the demand for B's currency goes up, and demand for A goes down.

And this is essentially what happened, relative to Japan and a lot of the rest of the world when Japan had its lower interest rates, all the way until really about 2008.

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Carry trade basics발음듣기

다른 번역문 등록

Let's say that the economy of Country A is stagnating, its maybe facing a deflationary crisis, so Central Bank tries to print as much money and lower interest rates as much as possible.발음듣기

다른 번역문 등록

And an investor can go into Country A and borrow in A's currency at a 1% interest rate.발음듣기

다른 번역문 등록

Lets also say that in the rest of the world, and in particular, in Country B, one can actually make relatively, or what you perceive as safe investments, at a higher interest rate in Country B's currency.발음듣기

다른 번역문 등록

And so lets say that you can get a 5% return.발음듣기

다른 번역문 등록

So you can imagine that some opportunistic investors might say "Wow I could borrow in Country A's currency" and so lets say they go into Country A.발음듣기

다른 번역문 등록

They borrow at 1% and in particular they borrow 100, and I won't call them Dollar's or Yen, or Euros.발음듣기

다른 번역문 등록

I'll call them 100 A's where the name of A's currency is an A.발음듣기

다른 번역문 등록

So they borrow 100 A's and lets say the conversion rate, right now at this point in time, 1A = 2B's.발음듣기

다른 번역문 등록

So they go into currency markets and they exchange it for every 1A they get 2B's.발음듣기

다른 번역문 등록

So they exchange it for 200 B's, and then they go and invest it, they are investing in B's.발음듣기

다른 번역문 등록

So they are borrowing in A's and they are investing in B's.발음듣기

다른 번역문 등록

And so what would happen?발음듣기

다른 번역문 등록

Well, they're going to get 5% on their money in B's, so 5% of 200, they're going to get 10 B's (lets say that's per year)발음듣기

다른 번역문 등록

So they're going to get 10 B's in interest every year.발음듣기

다른 번역문 등록

And then they can convert that.발음듣기

다른 번역문 등록

They can convert those 10 B's, if we assume the exchange rate holds constant, and that is a big assumption.발음듣기

다른 번역문 등록

They can convert that to 5A's based on the same exchange rate.발음듣기

다른 번역문 등록

So that will be 5 A's, but they only have to pay 1A in interest, and so they're just going to get 4 A's per year, if we assume constant exchange rate, they're going to get 4 A's a year for free.발음듣기

다른 번역문 등록

Assuming that they could continue to do this and then they could take those 4 A's and convert them to B's or whatever other currency they want.발음듣기

다른 번역문 등록

So you could say they're getting 4 A's for free every year, or they're getting 8 B's per year every year.발음듣기

다른 번역문 등록

And this little process, this trade, this little perceived arbitrage that's going on right over here, this is called the carry trade.발음듣기

다른 번역문 등록

You might think, where would this break down?발음듣기

다른 번역문 등록

Well the main area where this would break down is while you were borrowing in A, then investing in B, if A's currency appreciates, especially relative to B's currency,발음듣기

다른 번역문 등록

because then what happens, even though you have this interest rate discrepancy and even though you feel like your getting 10 B's, those 10 B's are going to give you fewer and fewer A's if A keeps appreciating.발음듣기

다른 번역문 등록

Or another way to think about it is, your going to in terms of B's, even though you think you only owe 1% interest A is also going to appreciate, so in terms of B's your going to owe more and more B's every year if A appreciates.발음듣기

다른 번역문 등록

Now what's worked out in the carry trade or at least the most famous of the carry trades, where starting in the mid-90's,발음듣기

다른 번역문 등록

people started borrowing in Japan because they had low interest and then investing other places, like the US, and especially other places like Iceland, is that the more people do this.발음듣기

다른 번역문 등록

So you can imagine, if a lot of people keep doing this and it becomes kind of a big herd effect, what happens?발음듣기

다른 번역문 등록

You have a bunch of people borrowing in A and then converting it to B.발음듣기

다른 번역문 등록

So they're taking this currency and converting it to the magenta currency.발음듣기

다른 번역문 등록

And if that happens, then you actually have the opposite effect.발음듣기

다른 번역문 등록

Then you have a benefit on top of the interest rate discrepancy because that means the demand for B's currency goes up, and demand for A goes down.발음듣기

다른 번역문 등록

And this is essentially what happened, relative to Japan and a lot of the rest of the world when Japan had its lower interest rates, all the way until really about 2008.발음듣기

다른 번역문 등록

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