Carry

The carry of an asset is the return obtained from holding it (if positive), or the cost of holding it (if negative) (see also Cost of carry).

For instance, commodities are usually negative carry assets, as they incur storage costs or may suffer from depreciation, but in some circumstances, commodities can be positive carry assets if the market is willing to pay a premium for its demand.

This can also refer to a trade with more than one leg, where you earn the spread between borrowing a low carry asset and lending a high carry one.

Carry trades are not arbitrages: pure arbitrages make money no matter what; carry trades make money only if nothing changes against the carry's favor.

Interest rates

For instance, the traditional income stream from commercial banks is to borrow cheap (at the low overnight rate, i.e., the rate at which they pay depositors) and lend expensive (at the long-term rate, which is usually higher than the short-term rate).

This works with an upward-sloping yield curve, but it loses money if the curve becomes inverted. The floating of short-term rates, for example, when Paul Volcker was the chairman of the Federal Reserve resulted in exactly this problem and was an important cause of the Savings and Loan crisis.

According to a popular anecdote, traditional commercial banking was characterized as a "3-6-3" business: borrow at 3%, lend at 6% (thus earning the 3% spread), be on the golf course by 3 pm.^[1] While this may have been close to the truth in the market of the 1950s to the 1970s, the modern competitive market ensures that profits are kept more in line with perceived risks.

Currency

The term carry trade without further modification refers to currency carry trade: investors borrow low-yielding currencies and lend (invest in) high-yielding currencies. It tends to correlate with global financial and exchange rate stability, and retracts in use during global liquidity shortages.^[2]

The risk in carry trading is that foreign exchange rates may change to the effect that the investor would have to pay back more expensive currency with less valuable currency.^[3] In theory, according to uncovered interest rate parity, carry trades should not yield a predictable profit because the difference in interest rates between two countries should equal the rate at which investors expect the low-interest-rate currency to rise against the high-interest-rate one. However, carry trades weaken the currency that is borrowed, because investors sell the borrowed money by converting it to other currencies.

By early year 2007, it was estimated that some US$1 trillion may be staked on the yen carry trade.^[4] Since the mid-90's, the Bank of Japan has set Japanese interest rates at very low levels making it profitable to borrow Japanese yen to fund activities in other currencies.^[5] These activities include subprime lending in the USA, and funding of emerging markets, especially BRIC countries and resource rich countries.

Known Risks

The 2008–2009 Icelandic financial crisis has among its origins the undisciplined use of the carry trade. The US dollar and the yen have been the currencies most heavily used in carry trade transactions since the 1990s. There is some substantial mathematical evidence in macroeconomics that larger economies have more immunity to the disruptive aspects of the carry trade mainly due to the sheer quantity of their existing currency compared to the limited amount used for FOREX carry trades.^{[citation needed]}

Notes

1. ^ The 3-6-3 rule : an urban myth? by John R. Walter, Federal Reserve Bank of Richmond Economic Quarterly
2. ^ CFR Effect of the Rising Yen March 14, 2007 retrieved 3-15-2007
3. ^ Why is the carry trade so dangerous? MoneyWeek, 10-27-2006
4. ^ What keeps bankers awake at night?, The Economist, Feb 1st 2007
5. ^ http://www.economagic.com/em-cgi/data.exe/bjap/ehdis01

See also

• endaka

External links

• The Yen Carry Trade Revisited
• The Unwinding of the Carry Trade Has Finally Hit Currencies by Jeffrey Frankel, Harvard Kennedy School, Oct. 29, 2008
• The Effects of the Yen Carry Trade Unwinding
• The Trade of the Decade by Nicholas Vardy - March 6, 2007
• "GETTING TECHNICAL: A Secret Time Bomb Made of Gold"
• An explanation of the carry trade
• Mother of all carry trades faces an inevitable bust by Nouriel Roubini, 1 Nov 2009.