The carry trade essentially involves taking advantage of low borrowing costs in
one country (Japan for instance) and high fixed income investment rates in another
country (New Zealand and Australia for instance). You get paid to 'carry' the trade
over time. Traders use this strategy to capture the difference between the prevailing
interest rates in the respective countries.
Through the forward market, the foreign exchange market provides a 'short-cut' for
borrowing in the low interest rate country and investing in the high interest rate
country. It eliminates the need to go through the actual process of borrowing (in
Japan) and investing (in New Zealand or Australia).
The forward market reflects the interest rate differential in the forward points.
So rather than having to actually borrow and convert yen, all a money manager has
to do is sell JPY forward and buy AUD forward in one simple transaction. Because
of the low interest rates in Japan and high interest rates in Australia, the yen
trades at a forward premium relative to the Australian dollar, and a seller of JPY
against AUD picks up these premium points.
There are certainly money managers and investors who do that through the fixed income
markets in Japan and Australia and New Zealand, but borrowing in Japan and investing
elsewhere involves a lot of legal and accounting costs, not to mention tax implications
that most money managers would rather avoid if possible. The currency market simplifies
the process through the forward market.
At the end of the forward term, if the spot rate has moved up you will have an FX
gain to add to your carry gain. But if the spot rate moves down, as it did in dramatic
fashion recently in 2009, the FX loss will cut into your carry gain and may even
wipe it out.
Here's an example of a "yen carry trade": a trader borrows 1,000 yen from a Japanese
bank, converts the funds into U.S. dollars and buys a bond for the equivalent amount.
Let's assume that the bond pays 4.5% and the Japanese interest rate is set at 0%.
The trader stands to make a profit of 4.5% (4.5% - 0%), as long as the exchange
rate between the countries does not change. Many professional traders use this trade
because the gains can become very large when leverage is taken into consideration.
If the trader in our example uses a common leverage factor of 10:1, then they can
stand to make a profit of 45%.
The big risk in a carry trade is the uncertainty of exchange rates. Using the example
above, if the U.S. dollar was to fall in value relative to the Japanese yen, then
the trader would run the risk of losing money. Also, these transactions are generally
done with a lot of leverage, so a small movement in exchange rates can result in
huge losses unless hedged appropriately.
The Basics of a Spot Transaction