What is the currency carry trade?

What is the currency carry trade?

Assets that are held are sometimes analyzed in terms of the cost of carrying them, called the cost of carry.

In certain situations, there may be a potential for profit if an asset that might otherwise have a cost of carry could be traded for an asset that actually generates profit. The arbitrage opportunity that exists in that space, and the market formed by it, is sometimes called the carry trade, or the currency carry trade where it applies to currency.

Today there is a prolific currency carry trade that exists because of the extremely low interest rates in Japan and some other countries. Investment banks and hedge funds can borrow large amounts of yen, paying extremely low interest rates, and use the yen to purchase US Treasury Bonds (after converting to dollars).

The risk-free interest paid on US Treasuries is substantially higher than the interest owed to the Japanese lender. By carrying Japanese debt, the arbitrageur has managed to make money. This is a form of uncovered interest rate arbitrage, where covered would mean that a forward contract was eliminating any interest rate risk.

The average investor will not be able to take significant positions to exploit this opportunity because it requires a very large amount of capital to be involved since it involves two very large loans. Basically, money is borrowed from a low rate environment and loaned out in a higher interest rate environment.

The Carry Trade is becoming a large market with several trillion dollars involved. Economists can point to the existence of this market to explain some anomalies in the interest rate environment that would not occur without the interventionist policies that are keeping the Yen low.