- Carry (investment)
For instance, commodities are usually negative carry assets, as they incur storage costs or may suffer from depreciation, but in some circumstances, appropriately hedged commodities can be positive carry assets if the forward/futures market is willing to pay sufficient premium for future delivery.
This can also refer to a trade with more than one leg, where you earn the spread between borrowing a low carry asset and lending a high carry one; such as gold during financial crisis, due to its safe haven quality.
Carry trades are not arbitrages: pure arbitrages make money no matter what; carry trades make money only if nothing changes against the carry's favor.
Interest rates carry trade / Maturity Transformation
For instance, the traditional income stream from commercial banks is to borrow cheap (at the low overnight rate, i.e., the rate at which they pay depositors) and lend expensive (at the long-term rate, which is usually higher than the short-term rate).
This works with an upward-sloping yield curve, but it loses money if the curve becomes inverted. Many investment banks, such as Bear Stearns, have failed because they borrowed cheap short-term money to fund higher interest bearing long-term positions. When the long-term positions default, or the short-term interest rate rises too high (or there are simply no lenders), the bank cannot meet its short-term liabilities and goes under.
According to a popular anecdote, traditional commercial banking was characterized as a "3-6-3" business: borrow at 3%, lend at 6% (thus earning the 3% spread), be on the golf course by 3 pm. While this may have been close to the truth in the market of the 1950s to the 1970s, the modern competitive market ensures that profits are kept more in line with perceived risks.
The currency carry trade is an uncovered interest arbitrage.
The term carry trade without further modification refers to currency carry trade: investors borrow low-yielding currencies and lend (invest in) high-yielding currencies. It is thought to correlate with global financial and exchange rate stability and retracts in use during global liquidity shortages, but the carry trade is often blamed for rapid currency value collapse and appreciation.
The risk in carry trading is that foreign exchange rates may change to the effect that the investor would have to pay back more expensive currency with less valuable currency. In theory, according to uncovered interest rate parity, carry trades should not yield a predictable profit because the difference in interest rates between two countries should equal the rate at which investors expect the low-interest-rate currency to rise against the high-interest-rate one. However, carry trades weaken the currency that is borrowed, because investors sell the borrowed money by converting it to other currencies.
By early year 2007, it was estimated that some US$1 trillion may have been staked on the yen carry trade. Since the mid-90's, the Bank of Japan has set Japanese interest rates at very low levels making it profitable to borrow Japanese yen to fund activities in other currencies. These activities include subprime lending in the USA, and funding of emerging markets, especially BRIC countries and resource rich countries. The trade largely collapsed in 2008 particularly in regards to the yen.
The 2008–2011 Icelandic financial crisis has among its origins the undisciplined use of the carry trade. Particular attention has been focused on the use of Euro denominated loans to purchase homes and other assets within Iceland. Most of these loans defaulted when the relative value of the Euro appreciated dramatically causing loan payment to be unaffordable.
The US dollar and the yen have been the currencies most heavily used in carry trade transactions since the 1990s. There is some substantial mathematical evidence in macroeconomics that larger economies have more immunity to the disruptive aspects of the carry trade mainly due to the sheer quantity of their existing currency compared to the limited amount used for FOREX carry trades, but the collapse of the carry trade in 2008 is often blamed within Japan for a rapid appreciation of the yen. As a currency appreciates there is pressure to cover any debts in that currency by converting foreign assets into that currency, so this can be an accelerating effect in currency valuation changes. When a large swing occurs, this can cause a carry reversal. The timing of the carry reversal in 2008 contributed substantially to the credit crunch which caused the 2008 global financial crisis. Though, relative size of impact of the carry trade with other factors is debatable. A similar rapid appreciation of the US dollar occurred at the same time, and the carry trade is rarely discussed as a factor for this appreciation.
- Convenience yield
- Carrying charge
- Cost of carry
- Demurrage (currency)
- Interest rate parity
- Covered interest arbitrage
- Spot-future parity
- ^ Maturity-transformation: http://www.macroresilience.com/2010/04/04/maturity-transformation-and-the-yield-curve/
- ^ The 3-6-3 rule : an urban myth? by John R. Walter, Federal Reserve Bank of Richmond Economic Quarterly
- ^ CFR Effect of the Rising Yen, March 14, 2007 retrieved 3-15-2007
- ^ Why is the carry trade so dangerous? MoneyWeek, 10-27-2006
- ^ What keeps bankers awake at night?, The Economist, Feb 1st 2007
- ^ http://www.economagic.com/em-cgi/data.exe/bjap/ehdis01
- The Yen Carry Trade Revisited
- The Unwinding of the Carry Trade Has Finally Hit Currencies by Jeffrey Frankel, Harvard Kennedy School, Oct. 29, 2008
- The Effects of the Yen Carry Trade Unwinding
- "GETTING TECHNICAL: A Secret Time Bomb Made of Gold"
- An explanation of the carry trade
- Mother of all carry trades faces an inevitable bust by Nouriel Roubini, 1 Nov 2009
- Carry Trades and Speculative Dynamics by Guillaume Plantin and Hyun Song Shin, May 2010. Explains the dynamics of the carry trade by the example of Iceland and then goes on to develop a mathematical model for the exchange rate movements caused by carry trades.
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