The Process Of A Carry Trade Economics Essay

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A managed fund is interested in participating in carry trades but is unaware of the nature of the trades and associated risks that may be involved. This report will focus upon the market conditions that need to exist to allow carry trades to be profitable. Historically, carry trades first came to prominence in the late 1980’s, as such we will focus on market conditions and their impact to the success of carry trades from the period of 1980 onwards.

The speculator of a carry trade borrow the currency that has a low interest rate and utilise those funds to purchase a currency with high interest rate and to this, the speculator would purchase a financial instrument with higher rate that has a maturity matching their expected duration of the trade (Brunnermeier, Nagel and Pedersen, 2009). The unwinding of this transaction requires the sale of the financial instrument and the repurchase of original currency to close the original loan that was entered by the speculator.

We then reviewed journal articles, analysis of market spectators and financial regulators, occasionally posthumously to observe when market conditions were conducive to carry trades being a profitable strategy.

The strategies taken for a profitable carry trade is based on the theory of demand and supply (Francis, 2011). From the analysis it is evident that interest rates and currency rates play a major role in determining the profitability of a carry trade. The factors affecting the exchange rate and the interest rate are discussed below.

Our discussion starts with the market conditions that are favourable to carry trades. This consists of selling low interest rate currencies and investing in high interest rate currencies. Effectively selling currencies forward realise significant forward premium (Hattori and Shin, 2009; Brunnermeier, Nagel and Pedersen, 2009).

A comparative analysis of the trading period 1996 - 1998 demonstrates an optimum environment for a profitable carry trade. This is evident from the upward trending USD/JPY currency pairing. Also occurring during this period is a stable low interest rate on JPY and a comparatively high interest rate for USD.

This prime environment is shown in Figure 4 with USD/JPY reaching a low of 80 towards the end of 1995 and then trending upwards. Figure 5 demonstrates the JPY interest rate, remained at a stable low during this period. Conversely, figure 6 displays the relatively high US interest rate, which remained constant over the same period.

The combined effect of these conditions created a profitable USD/JPY carry trade. This resulted in the forex transaction generating profits alongside interest being earned for the life of the carry trade. Purchasing the USD/JPY pair early 1997 meant earning 5.5% per annum holding US Dollars and paying 0.5% per annum borrowing Japanese Yen. This provides the opportunity to earn 5% interest on the carry trade as seen throughout figures 5 and 6.

A more recent example can be seen in figures 1, 2 and 3, which reveal a similar trend in the AUD/JPY currency pairing during 2010- 2011. This contemporary example reveals the trending up of the forex rate from an AUD/JPY low of 75 mid 2010. Again, the interest rate of JPY was being kept low at 0.1 to 0.0 due to government intervention. Simultaneously, a 3% to 4.95% interest rate of AUD was relatively high. Purchasing the AUD/JPY currency pair in mid 2010 meant earning 4.5% per annum holding Australian Dollars and paying 0.1% per annum borrowing Japanese Yen. This provides the opportunity to earn 4.4% interest on the carry trade. This is an example that shows profits on the forex transaction also generated income from interest earned.

Profitability of these transactions is further enhanced by leveraging the forex trade. This serves to magnify the profits generated from the interest rate differential. However, this also exposes the carry trade speculator to the greater losses particularly when closing the carry trade transaction.

In October 1998, the Russian Bond Crisis necessitated Long Term Capital Management (LTCM) and other currency based managed funds to close out their previously profitable carry trade strategy and the funds had sometime used highly leveraged USD/JPY carry trade (Melvin & Taylor, 2009). Due to the default of the Russian bond market LTCM had to move quickly to minimize their risk exposure. This meant the rapid repurchase of the JPY currency, which resulted in the USD/JPY pair falling sharply from 136 JPY to 111.50 JPY within a single week in October 1998 (Reuters, 2008).

To conclude, a carry trade strategy of choosing a currency pair with the highest interest rate spread can help in a profitable trade. Different lending and borrowing rates are needed for a carry trade to be performed. All the strategies are based on the demand and supply. The investors from Japan made huge profits during 2003 to 2007 through carry trade and there after it became more popular (Morgan, 2011). The changing interest rates clearly affect the investors return. To sum up it is advisable to use the strategies of carry trade under favourable market conditions and not to perform these strategies under financial market crisis.