A carry trade is a popular technique among currency traders in which a trader borrows a currency at a low interest rate to finance the purchase of another currency earning a higher interest rate.
Exchanging Carrying Costs
The term has its origins in the financial concept of "carry," or the profit or cost associated with holding (i.e. carrying) a particular asset. When holding one asset relative to another generates a profit, it is understood to have a "positive carry." Likewise, when holding an asset generates a loss relative to another, it is understood to have a "negative carry."
Thus, the idea of carry trade in its most general form is trade aimed at trying to generate a profitable return by exchanging two assets with differing relative carrying costs. In more technical parlance, the trade has been described as a type of "interest arbitrage."
As an example, an investor could borrow money from the bank at a rate of 1% annually and invest that money in the purchase of a currency in a nation where the interest rate is 5%. The investor would make a net return of 4% annually on that investment for the period over which the trade was in effect (or loss of 4% if the rates were reversed).
In a currency carry trade, an investor potentially stands to profit or lose both from the relative movement of the exchange rate and the interest rate differential between the two currencies. Markets that present a high interest rate differential often present higher currency volatility, and an unexpected weakening of the target currency purchased could generate losses. To be profitable, the interest rate differential of a carry trade must be greater than the possible weakening of the target currency over the period of time that the trade is executed.
Against the Theory: The Forward Premium Puzzle
Under the economic theory of uncovered interest rate parity (UIP), carry trade is not expected to produce a profit because currency values should adjust according to the interest rate differential between two countries. In practice, however, currencies of countries with higher interest rates have been found to appreciate rather than depreciate as the theory states. This phenomenon has been called the "forward premium puzzle" by scholars, and has been in part attributed to the fact that heavy selling of a borrowed currency in trading tends to weaken it.
The Yen Carry
The practice of carry trade in currency markets gained popularity in the 1990s. Currency traders, especially at hedge funds, began to see opportunity in the large interest rate differentials between the economies in countries like Japan, Australia and the U.S. At the time, interest rates in Japan had dropped near zero, while rates in the U.S. were near 5% or above.
Carry trades have been especially popular for investment in emerging markets, which because of their macroeconomic characteristics have tended to present high interest rate differentials. At the same time, authorities in those countries have found the practice of carry trade in large volumes to present problems, as it tends to bid up the value of those currencies and then produce a dramatic depreciation when the carry trade positions are later reversed en masse.
Common Carry Trade Strategies
Currency carry trades can be made with simple cash transactions involving the purchase of foreign currencies. However, according to the Bank for International Settlements (BIS), they are most frequently made through derivatives market operations, including futures, forwards, forex swaps and options. Also, they are often made over a period of 6 months or less.
The common strategies of carry trade that the BIS identifies includes direct acquisition of debt in a high-interest-yielding currency using borrowed funds in a low interest currency. At settlement, the investor sells the debt and repurchases the funding currency to repay the initial amount borrowed.
An alternative strategy used by investors is to take a long forward position in the high-interest currency using deliverable forex swaps. This strategy involves the purchase of the low-interest currency on the spot market and the purchase of the target currency with a forward transaction. At settlement, the investor receives the target currency and delivers the low-interest funding currency, using the proceeds of the transaction to repurchase the funding currency on the spot market. This strategy is considered to offer the advantage that positions can be quickly unwound if needed.
Another popular strategy is to take a non-deliverable short position in a low-yielding currency and a long position in a high-yielding target currency. Upon settlement, the purchaser receives, or pays, the difference between the forward rate and the spot rate if the target currency appreciates or depreciates in relation to the agreed-upon price of the non-deliverable forward. This strategy is popular because the transaction involving a non-deliverable contract can be made with a relatively smaller initial investment than with alternative strategies.
A swap is a financial derivative product that helps firms and institutions manage risk. A plain vanilla swap, also known as a generic swap, is the most basic type of such transaction. Similar in function to standardised futures and forward contracts, a plain vanilla swap is an agreement between two parties that specifies an exchange of periodic cash flows arising from an asset class or debt instrument.
Corporations, high net worth investors and institutions are the most common purveyors of plain vanilla swaps. Typically, this form of transaction is executed in relation to the following assets:
- Interest rates: Interest rate swaps facilitate the exchange of payments derived from fixed rate debt obligations for variable rate payments and vice-versa.
- Currencies: Currency swaps enable the interchanging of nominal amounts of foreign currencies. The international debt market, exchange rates and an entity's entrance into a new country or foreign market are a few motivations for this type of transaction.
- Commodities: Commodity swaps are used to hedge against the inherent volatilities facing a specific market or markets. Agricultural and energy products are among the most commonly involved in commodity swaps.
Plain Vanilla Swap: Parameters And Mechanics
The mechanics of a plain vanilla interest rate swap are fairly straightforward and similar to those involving currencies and commodities. In this type of swap, two parties decide to exchange periodic payments with one another according to specified parameters using interest rates as the basis for the agreement.
For instance, Commercial Bank Z and Company X agree that it may be beneficial to trade payments with one another based upon their own specific circumstances. In order to structure the swap, the following parameters are defined and agreed upon:
- Principal amount: The amount of capital involved in the debt service.
- Duration: Period of time until the agreement reaches maturity, including the payment schedule.
- Denomination of currency: Type of currency in which the payments are to be made.
- Interest rates: The interest rates by which the trade is bound. Fixed and variable rates are defined by the participants. Reference to an interest rate index, for example the London Interbank Rate (LIBOR), is common practice to define the variable rate.
The transaction commences involving Commercial Bank Z and Company X:
- Company X and Bank Z agree upon a principle of US$100 million, duration of 5 years, with payments due twice per year.
- Bank Z makes payments based upon a fixed 10%, while Company X agrees to make its payments based upon a variable rate of 2% + current LIBOR.
- The payments are processed by an intermediary, with fluctuations in the variable interest rate acting as the primary determinant of success for each party.
The swap itself may have many results and be either helpful or detrimental to the participants involved. For instance, Company X may enjoy the value of having a constant stream of revenue generated by the payments from Bank Z. Conversely, Bank Z may benefit from rising interest rates and larger payments received from Company X.
Ultimately, the motivation for entering into the agreement depends upon the individual participants involved. Common reasons for engaging in a plain vanilla swap range from managing risk to capitalising upon fluctuations in various markets.
Summary: The Swap Debate
Although an integral part of the global derivatives market, many kinds of swaps remain controversial. During the credit crisis of 2008, credit default swaps (CDS) pertaining to the U.S. real estate market were deemed to be one of the primary culprits responsible for the meltdown. The subsequent failure of numerous investment banks and insurance companies were attributed to these activities, giving the term "swap" a somewhat negative connotation.
However, the swap has a history dating all the way back to 1981, originating with a trade of currency yields and debt obligations between IBM and the World Bank. Since then, swaps have become an enormous over-the-counter (OTC) marketplace. For the year-end 2015, swaps accounted for 75% of the total interest rate derivatives market, a value of US$320 trillion.
In general, there are many distinct varieties of swaps, each with its own degree of complexity and popularity. Plain vanilla swaps are the most commonly executed type of swap, and often a viable method of actively managing risk while securing profit.
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