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Carry Trade Explained

Carry Trade Explained

You might have heard the word, carry trade, but may not know what it means. In this article, we have explained this form of investment in layman's terms.
Rimlee Bhuyan
Financial jargon is notoriously difficult to decipher and understand. In most cases, the explanation of an economist or financial analyst is simply not understandable for laymen, who barely manage to understand the difference between stocks and mutual funds, or debt and equity. So, if you are like me, who gets hopelessly muddled in words like systematic investment fund, collateral, negative equity, reverse mortgages, and credit crunch, then you need to look beyond the jargon to understand these terms.

Concept

Carry trade, in layman's terms, means borrowing a currency that has a low interest rate and converting it into a high interest yielding currency, and then lending it. It is an extremely risky way of making quick money, as the currency market is very volatile in nature.

Basically, it consists of borrowing money at a cheaper rate and investing it somewhere you can earn higher returns from. For example, an investor borrows money in a low interest rate currency like the Japanese yen or Swiss franc, and then invests it in a higher yield currency like the US dollar. People also purchase assets such as Icelandic housing bonds. This gives superior returns and has lured many investors into currency carry trade.

Current Scenario

For economic recovery post the recession, the US Federal Reserve has kept the interest rates at a low level, which is unheard of. According to this policy, small businesses and consumers can get easy funds by taking loans at an artificially low interest rate. But investors take advantage of this and borrow large sums of money, only to invest it in assets outside the country, which will yield much higher returns.

Let us suppose that the interest rate for a commercial loan in the United States is 2% and the same loan in Australia is at 5%. An investor will take a loan at 2% interest rate in the US and exchange the money in Australian dollars. He then proceeds to invest the money in bonds. If there are no market fluctuations, this trade will earn him a profit of 3% without him having to invest a single penny of his own.

Risk Factor

Carry trade might seem like a very attractive way to make a quick buck, but there are many risk factors involved that you should be aware of. The biggest factor, of course, is the uncertainty of exchange rates. In the example given above, if the Australian dollar weakens or devalues, reducing the assets relative to the borrowing, the investor will face substantial losses, and will still have to pay back the debt in US dollars.

Therefore, it should be best left to those traders who can cope with any potential losses. Now that you know what this concept is all about, you can decide for yourself, if you have what it takes to invest in this asset, or should you stick to more conservative investments.

Disclaimer: This article is for reference purposes only and does not directly recommend any specific investment choices.