Financial markets are like oceans. When the tide is low, you enjoy the flow. But when the tide is rough, sailing gets tough. Few know this better than carry traders. Their lives start on one tide and end on another. In between the rise and fall of tides, numerous questions arise. How does carry trade work? What are the risks? These questions leave our friend Johnny clueless. But there is no need to worry when Jinny is around.
Shailaja and Manoj K. Singh
Jinny: Hi Johnny! Nice to see you. But why are you playing ping-pong today?
Johnny: Jinny, I was thinking of doing the great ping-pong ball experiment for the financial markets. Even big ships sometimes can’t survive the rough tide, but a simple ping-pong ball can float long distances without any problem. Can’t we have something like a ping-pong ball for the financial markets that can keep on floating come what may?
Jinny: Sounds interesting. What is making you so thoughtful today?
Johnny: I was just wondering what inspires carry traders to take risks when they know they may sink if the tide turns.
Jinny: Well, it is very tempting to jump in the waters when you see easy money flowing around.
In financial markets, carry trade is like fishing for the flowing money. Its working looks so simple that you could say, “Wow! I can do it too.” But how? The answer is pretty straightforward; you borrow at a low rate and invest that money in a high-yielding investment. Is that all? Yes, that’s it.
I will give you an example of a simple carry trade. If the short-term interest rate is less and long-term interest rate is high, you borrow money for the short term and lend the same for the long term. But there is one problem. You would be required to repay your short term borrowing much before you receive repayment from your long term borrower. What would you do? You again borrow for the short term and repay your earlier loan. In this manner you keep your boat sailing. But the problem is that any rise in short term interest rates can sink your boat.If you are ready, we can now move on to a more advanced version of carry trade, popularly known as the currency carry trade, that takes place in the foreign exchange markets.
Johnny: Sure, go ahead.
Jinny: Currency carry trade works on the basis of interest rate differentials of two currencies. Many factors decide what would be the interest rates for a debt denominated in a particular currency. Similarly, many factors decide what would be the exchange rate of one currency against another. For doing carry trade, you borrow the currency which is available at a lower interest rate and convert the same into the currency which is available at a higher interest rate. By doing so, you can invest your money in the debt instruments of the currency carrying a higher interest rate. In this manner, you pay less interest on your loan and get high interest on your investments. This is how currency carry trade works. Currency carry trade is a type of interest rate arbitrage. If you are borrowing Japanese yen to purchase some other currency, then it is called “yen carry trade”. But remember, unlike risk-free profits in other arbitrage opportunities, currency carry trades face many risks.
Johnny: Really? What are the risks?
Jinny: There are two predominant risks. The first is interest rate risk and the second is exchange rate risk.
If the interest rate of the currency that you have borrowed increases, then the gap between the interest rate of the currency that you borrowed and the currency that you have invested will get narrowed. This will reduce your profit margin.
Similarly, the exchange rate of the two currencies also plays a major role. If the currency you have borrowed appreciates, your debt liability increases, and if it depreciates, your debt liability decreases. So you make a profit when your borrowed currency depreciates and you suffer a loss when the borrowed currency appreciates.
Johnny: This puzzle of appreciation and depreciation is a bit confusing. Please explain this with an example.
Jinny: Okay, let’s put it this way. Suppose you borrow Rs5,000 and get this amount converted into $100 at the rate of Rs50 for a dollar. Suppose, after two years you have to repay your debt, for which you will require to convert your dollars into rupees. During these two years, suppose the rupee has appreciated and the exchange rate has become Rs25 to the dollar. At this rate, you would require $200 to purchase Rs5,000. But suppose the rupee depreciates and the exchange rate has become Rs100 for a dollar. Then you would require only $50 to purchase Rs5,000. I think the arithmetic of profit and loss is now clear to you.
Johnny: Yes Jinny. I now also understand what makes a ping-pong ball safer than carry trades.
IN A NUTSHELL:
What:Borrowing one currency at low interest rate for purchasing another currency paying high interest rate is called currency carry trade.
How: Traders earn profit by taking advantage of difference in interest rates of the two currencies.
Why: Any adverse movement of interest rates or exchange rates may bring about unwinding of currency carry trades.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat.
You can write to both of them at firstname.lastname@example.org