what is carry trade?

Question

the recent downfall of stocks worldwide is considered to be the result of the carry trade with compination of the increase of the value of yen. Can someone explain this?

Answer 1

The carry trade is when an investors borrows in one currency such as the Yen which carries with it a 0.5% interest rate and uses that money to invest in something with a better return. For example, a US investor sells the Yen against the US Dollar and with margin rates of 1%, he is using only $1000 to borrow $100,000 worth of Yen for a period of time. He then turns around and buys the New Zealand Dollar against the US Dollar and receives an interest rate of 7.5%, making a net of 7%. But since he only invested $1000 to borrow that $100,000 worth of Yen, his return is much higher than 7%.

Sort of an equivalent to the carry is if you found an investment that would pay you 12%. You take out a home equity loan on your house at 6% and use the money for that 12% investment.

Now, as for the carry trade causing stocks to go down, it's actually the other way around, the downfall of stocks is causing the carry trade to unwind. What start the whole thing is that the Chinese government felt the 11% growth in their economy last year was too high and wanted to make it more reasonable (8%). They instituted some rules to cause that slowdown to occur. Investors in the high-flying Chinese stock markets were worried about how a slowdown would affect their stock gains and started taking profits. It snowballed and became a full-fledged correction. Other world markets saw this, felt the slowdown would affect the rest of the world and they started selling.

This slowdown and the effect it might have on commodities caused an effective increase in risk in the carry trade. Traders that were unwilling to carry that extra risk started closing out their carry trades. As some started doing it causing the Yen to increase in value (they had to buy the yen to close out their Yen-short position). When they did this, they had to also close out their offsetting trade, usually in either the Australian Dollar or New Zealand Dollar causing those currencies to go down. Same thing happened with the Euro and the Pound. With Canada being a large producer of commodities and with the fear that commodities would take a hit, the Loonie (Canadian Dollar) declined.

Hope that explains it some.

Answer 2

A trade where you borrow and pay interest in order to buy something else that has higher interest. For example, with a positively sloped term structure (short rates lower than long rates), one might borrow at low short term rates and finance the purchase of long-term bonds. The carry return is the coupon on the bonds minus the interest costs of the short-term borrowing. Of course, if long-term interest rates unexpectedly rose(and long-term bond prices fell as a result), the carry trade could become unprofitable. Indeed, if this occured, there could be a number of investors trying to unwind the carry trade, which would involve selling the long-term bonds. It is possible that this could exacerbate the increase in long-term interest rates, i.e. push the rates even higher.

Answer 3

The link below gives a definition.

There are two basic types -- one where you borrow short term and invest long term at higher rates. The other involves borrowing in one currency and investing in another -- where the interest rate is higher.