The new carry trade?

What is carry trade? Carry trade essentially means borrowing at a place where the borrowing costs are low and investing in another place where the rate of return is high. Carry trade became very popular in the last decade, when Japanese interest rates were close to zero. It came to be known as the Yen carry trade.

Let us look at how investors benefited from the near-zero interest rate in Japan and the high interest rate in other countries (like the US) in the past few years. In 2006, the interest rate in Japan was 0.1%. Let us say an investor borrowed a sum of 115,000 Yen in the Japanese market for one year. At the end of the year the investor will have to return 115,115 Yen (original amount of 115,000 + interest for one year which is 115,000 *0.1%).

In 2006 the interest rate in US was 5.25% and the currency exchange rate was around 1$ = 115 Yen. Suppose the investor converted his Yen to Dollars, he then got $1,000 (for his 115,000 Yen). If he then proceeded to invest his $1,000 in the US market, at the end of the year he would have $1,052.5 (original amount of $1,000 + interest for one year which is $1,000 * 5.25%).

If the currency exchange rate stayed the same, he would then get 121,037.5 Yen ($1,052.5 * 115) when he converts his Dollars to Yen. After repaying the amount due he will be left with 5,922.5 Yen (121,037.5 - 115,115). That is a neat profit considering the fact that all the investor had to do was borrow in one country and invest in another.

(the profit percentage is 5,922.5/115,000 = 5.15%, which is also equal to the difference in the interest rates of US and Japan)

The only risk the investor faces is that of the currency movement. The above calculation assumes that the Yen:Dollar exchange rate stays the same at the end of the year. However, if the Yen appreciates by more than 5.15%, then the investor effectively makes a loss (because he will have to pay more Dollars to get the Yen at the time of repayment).

Due to a host of reasons, the Yen has appreciated considerably in the past year with respect to the Dollar (refer figure). Thus the Yen:Dollar carry trade has come to an abrupt halt. Another reason that has hampered the carry trade is that the interest rates in US is also close to zero now (effectively there is no difference in interest rates in Japan and US).





Hence investors have now started borrowing from countries like Japan and US (where the interest rate is close to zero) to invest in countries where the interest rate is still high (Brazil and India). In Brazil, the interest rate is 11%, so an investor can potentially make twice as much as the Yen:Dollar trade in 2006! The assumption, of course, is that these currencies do not appreciate against the Dollar and the Yen.