Financial jargon is notoriously difficult to decipher and understand. If you happen to know any economist or financial analyst who can explain them to you, then in most cases their explanation is simply not understandable for lay men who can barely manage to know the difference between stocks and mutual funds and 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 get rid of the financial jargon to understand these terms. Carry trade in layman's term means borrowing a currency that has a low interest rate and converting it into a high interest giving currency and then lending it. It is a very risky way of making quick money as the currency market is very fluctuating in nature.
What is Carry Trade?
Basically, carry trade consists of borrowing money at a cheaper rate and investing it somewhere you can earn higher returns from. In a carry trade, the investor borrows money in a low interest rate currency like the Japanese Yen and Swiss Franc and then investing this in higher yield giving assets in a different currency. The higher yield giving currency is often the US dollar but people are also investing in assets such as Icelandic housing bonds. This gives superior returns for investment and this is what has lured many investors into currency carry trade.
For the recovery of the economy due to recession, the US Government and the Federal Reserve has kept the interest rates at a hitherto unheard of low level. According to this policy, small businesses and consumers can get easy funds by taking loans with such an artificially low interest rate, thereby helping the US economy to recover. But investors take advantage of this low interest rate and borrow large sums of money at a low interest rate and invest it in assets outside the country which will yield much higher returns.
Here carry trade is explained with the help of an example. Let us suppose that the interest rate for a commercial loan in United States is 2% and the same loan in Australia has a rate of interest at 5%. An investor simply takes advantage of the difference in the two rates of interest in different economies. An investor will take out a loan with the 2% interest rate in US and exchange the money in Australian dollars. He then proceeds to invest the money in bonds. If there is no market fluctuations this carry trade will earn him a profit of 3% without him having to invest a single penny of his own.
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 risk factor of course is the uncertainty of exchange rates and if the currency exchange rate works against you. If in the example given above of the Australian dollar weakens or devalues, reducing the assets relative to your borrowing. As a result, the investor will face substantial losses and they still have to pay back the debt in US dollars.
Carry trade can earn an investor very good returns even if they do not have any capital. But it can be risky if the volatility in currency exchange market takes place and it should be best left to those investors who can cope with any potential losses. Now that you know what is carry trade, you can decide for yourself if you have what it takes to risk investing in carry trade or should you stick to more conservative investments.
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