Carry Trade explained by CTA Chris Lori

What is a Carry Trade?
A Carry Trade is a strategy in which an investor sells a certain currency with a relatively low interest rate and the funds are used to purchase a different currency yielding a higher interest rate. A trader using this strategy attempts to capture the difference between the rates, which can be substantial depending on leverage used.

What is Your Risk?
The risk is the possibility of the currency cross rate moving against your position.

Short Term Interest Rates
JAPAN = 0.25%
SWISS = 1.50%
EURO = 3.25%
CAN = 4.25%
UK = 4.75%
US = 5.25%
AUS = 6.00%

Other factors to consider:
- Banks and Hedge Funds can borrow at near zero IR’s in Japan, or at low rates in Switzerland.
- They can lend anywhere in the world that offers higher yields – i.e. US Mortgages etc.
- This can fuel asset bubbles in spite of CB’s effort to control growth and over-heating of the economy.
- What happens to the Carry Trade when the market focus becomes diverted? Say, back to double deficit, or some other factor we are not presently considering?
- Oh, that will never happen! It’s going to the moon!

More factors:
- When was the last time the world saw the carry to this extreme?
- Watch the Bank of Japan to hint at tightening, which could spark an unwind.
- An unwind occurs when Carry Traders buy back Yen. Look at December 14-15, 2005.

Current JPY Speculation:
- Yen is undervalued relative to fair market value estimates.
- Part of Yen’s decline has been a function of Monetary Policy. Only 1 rate hike this year, lagging all others.
- IR spreads have moved against Yen.
- 2007 could see rate hikes in Japan and moves back into the currency.
- This could also be fueled by weakness in foreign regions and a move out of speculative carry positions.

Please see the link below for EUR/JPY weekly chart example with 1 year rate spread. We see a nice increase in evaluation of this pair along with the correlation between the interest rate differential (blue line) and the cross rate evaluation (orange line), which is reflected in the carry trade.

More carry trade examples with strategies that can be employed can be found in the guest AM Review from November 6, 2006. http://www.forexmentor.com/

eurjpy-weekly.GIF