The basic reasoning underlying the global carry trade is relatively straightforward--traders or investors borrow in a low-yielding currency and effectively place the borrowed funds on deposit in a high-yielding one. Simply put, they seek to exploit interest rate differentials between one country and another.
On the face of it, this is a relatively uncomplicated and profitable business, and the strategy is widely used during periods of global financial and exchange rate stability. A simple example: if overnight lending rates are an annualized 13.75% in Iceland compared to 0.5% in Japan, investors will borrow Japanese yen to fund an Icelandic krona deposit, pocketing the 13.25% difference, if they are unhedged, and provided the exchange rate remains stable.
Profiting from this transaction depends on the exchange rate between the two currencies not moving consequentially in favor of the borrowed currency. In a nutshell, the key to a successful carry trade is an interest rate differential and the belief that you can borrow cheap and lend expensive, but it isn't always that easy.
The fact is that exchange rates between currencies do vary. This introduces a substantial element of risk into the carry trade. On the upside, of course, it can be an added bonus if the currency offering the higher interest rate appreciates against the lower-rate one. According to Erik Postnieks, chief executive of Wooster Asset Management LLC, the "forward rate bias"--the tendency for higher interest rate currencies to not only not depreciate against lower-yielding currencies in any systematic way, but actually to appreciate against lower rate currencies over the longer term--is a trend that has remained intact over the past 25 years, and one that seems entirely likely to persist.
"Foreign exchange carry trades tend to focus on situations where there's a large differential between the interest rates of two countries and yet a high correlation between their currencies," says Postnieks. "Some analyze these differentials on the basis of currency pairs, but a portfolio approach is more appropriate."
According to Postnieks, most retail investors will consider the carry trade on the basis of a single-currency pair, since they don't have access to models that are sophisticated enough to use covariance matrices capable of analyzing the developing relationships among numerous currencies simultaneously, i.e., as a basket. "Ninety percent of all retail investors lose money in futures markets, and I would be surprised if things are any different in the foreign exchange markets," he says. "Retail investors don't have the time or tools to manage risk on [a] long-term basis."
Given all the complexities and risks and the growing number of participants, will the carry trade continue to yield profits for able traders in the future? Postnieks says the forward rate bias is one of the largest and longest-lasting anomalies in the financial markets. "Capital, in essence, gets trapped in low-interest, low-growth-rate, high-savings countries like Japan and Switzerland because of a natural home rate bias and the risk aversion of depositors in these countries," he opines.
"This provides an opportunity for risk-adjusted, return-maximizing hedge funds to reallocate capital from where it is in surplus to where it is most needed--higher interest rate countries with generally higher gross domestic product growth rates," Postniek concludes. "Viewed from this perspective, carry traders are performing a valuable function by allocating capital more efficiently than individual savers ever will."