BackDe-jargoned: Carry trade
Carry trade is basically a trade on interest rate arbitrage and its biggest risk is currency risk.
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The talk of the reviving yen carry trade in the global financial market is gathering momentum. The immediate trigger for the rise in interest in the yen carry trade is because the Japanese currency has depreciated significantly against other major currencies such as the dollar and the euro. The new Prime Minister of Japan, Shinzo Abe, is pushing for monetary easing by the Bank of Japan, the Japanese central bank, which has now raised its inflation target to 2% from 1% earlier and is likely to resume its asset purchase programme in a big way. Since the supply of yen will increase owing to asset purchase by the central bank, the currency is depreciating in anticipation and is likely to remain weak.
Yen carry trade was fairly popular in the 2000s, but as yen appreciated against major currencies in the later part of the decade, trades became unviable.
What is carry trade?
Carry trade is basically a trade on interest rate arbitrage. Traders borrow in currencies in which interest rates are low and invest in the countries where rates are high. For example, a trader can borrow at close to zero percent in Japan and invest in the Indian debt market at 8% and thereby gain.
These trades are extremely profitable as they are generally leveraged. For instance, if an American trader has $100 to invest and goes to Japan and borrows yen worth $1,000, say, at 1% and invests in India at 8%, $1,100 will earn $88 as interest at the end of the year. He would pay back his Japanese lender $10 as interest and will get to pocket $78—a gain of 78% on his $100 investment. Naturally, it is an extremely profitable trade and attracts a large number of traders to gain from this interest rate arbitrage.
The risk
The biggest risk in carry trade is the currency risk. For example, suppose a trader invests $100 in the Indian market after which the currency slips from 50 a dollar to 60 per dollar. In case the trader wants to exit, assuming no interest is accumulated, he will only get about $83. Similarly, the movement in the borrowing currency will affect returns.
The other big risk is to the financial stability of a country or the financial system since large amounts move across borders as part of carry trades. This could lead to problems on the currency front for a lot of countries. Therefore, it is important that policymakers are careful while opening up the capital account and ensure that adequate safeguards are in place.
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