Deciphering carry trades

Posted on 12. fév, 2010 by Jean Jacques Ohana in Weekly Focus | Commentaires fermés

Carry trades have been made popular in the past decade due to the stellar performance registered in this type of strategy. Basically, it consists in borrowing in low yield currencies and investing in high yield currencies, in order to exploit interest rates differentials between currencies.

What is more striking is the diverse business interest in this type of strategy.

Private individuals living in low yield countries such as Japan or Switzerland (presently mainly all G10 countries experience a zero rate environment) export capital to benefit from high yields in foreign currencies. For instance, Australia issued Uridashi bonds tailored to Japan investors, enabling them to finance current account deficit. These bonds have been highly popular in Japan, as reflected in the AUD/JPY price action from 2000 to 2007:

Companies operating in high yield currencies finance themselves by borrowing in low yield currencies. An example of such a situation has been observed in Mexico where companies needed to unwind all their US debt during the liquidity funding crisis following the Lehman collapse. This event has been revealing of the massive positions which were held by Mexican businesses before the Mexican peso lost 50% against the dollar in 5 months.

Even more absurd, individuals living in high yield countries are attracted by the low yields in neighbor countries to finance their mortgage. For example, in European Eastern countries, more than 50% of mortgages are financed in EUR or even CHF to minimize interest costs. The currency risk is often borne by financial intermediaries. Unfortunately, this risk manifested itself at the beginning of 2009 when several countries notably Hungary, Lithuania, Latvia and Romania were on the verge of failing to meet their debt obligation. The funding in low yield currencies induces a systemic risk since after fostering an artificial housing bubble it leads to a deleveraging spiral putting pressure on the mortgage-distributing banks.

Last but not least, traders use carry trade strategies to capture interest rates differentials among countries. These strategies, as profitable as they may be in normal situations, induce an additional systemic risk since they increase the magnitude of the carry trade theme, then increasing the potential losses and currency variations when positions are unwound. This situation is reflected in the performance of a basket of carry trades currencies (excluding carry):

For sure, carry trades, when invested modestly, enables countries with a negative current account to finance themselves. Nevertheless the relationships network (depicted below) between carry trades has so dramatically increased that these trades have become a weapon of mass destruction for the financial system as a whole:

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