First, a review of what the carry trade is might be helpful. Carry trade is a strategy which takes advantage of the different interest rates in different countries. The difference can be dramatic, as this table shows:

Generally, the difference in interest rates can be traced to the differences in risk of default in each country. As you can see, the Brazilian Real, the Turkish Lira and the South African Rand top the list, while the US and Japan hold down the bottom of the risk and return list. I am sure an interesting correlation could be made between the interest rate and the Sovereign Credit Default Swap rate (exercise left to the reader).

Historically, the JPY was used to fund the carry trade, but now the dollar is also a very attractive funding currency. With few signs that the US will exit its loose monetary policies any time soon, it looks likely to remain so at least through next year. One effect of carry trade is that the funding currency is weakened as it is sold to buy the higher-yielding currency, which strengthens on higher demand. This is the effect that weighed on the JPY between 1996 and 1998, and again between 2001 and 2008. Much of hedge fund returns can be traced to the carry trade. The size of the previous carry trade phase could have been as high as $1Trillion

There are several ways in which to play the carry trade. One way is to exchange one currency for another, and then invest in risk-free securities in that currency, such as bonds, which will earn more interest than in the base currency. This is a little cumbersome.

Another method is to initiate positions in the Forex market. For example, when an investor goes long the AUD/JPY, he is short a currency whose central bank pays 0.1%, and long a currency whose central bank pays 3.5%. An FX market maker will either pay out (or as appropriate, charge) a carry interest, which is what the investor is interested in. It is not usually as simple as taking the difference between the central bank rates, as the market maker adjusts daily, takes a spread, and bases the rate on indices (such as Libor) that closely track the central banks rates .

The Forex method is more common because it is easier to utilize leverage to enhance the interest rate difference. Assuming for the moment that the simple difference is what is paid, a 1:1 position in AUD/JPY would pay 3.5%-0.1% = 3.4%/annum; not an especially interesting number. However, F/X carry trade investors can utilize a higher leverage such as 10:1, which would generate a return of 34%, a very exciting number. OK, what’s the catch? It’s simple- the risk of the exchange rate moving against the investor.

For example, the BRL might be seen as an excellent choice of currency to be long. In the period from 2003 to 2007 the BRL appreciated from 4.0BRL/$ to 1.6BRL/$, a 250% rise. Not only were investors getting an enormous interest rate differential, but saw the currency appreciate as well. However, if you initiated this trade in early ’08, the BRL dropped 50% in value, more than wiping out any interest rate differential. This risk can be mitigated in several ways.

• One way is to stick with the majors. Which the rate differentials are not as high, leverage can boost returns and the exchange rates don’t exhibit extraordinary volatility.

• A second way is to buy insurance. There are option strategies (eg collars) which limit the effects of exchange rate volatility, while allowing an investor to benefit from rate differentials. The cost of the collar is minor, depending on the leverage utilized. N.B this is also the tactic major import-exporters use to insure against F/X exposure, along with forwards.

An investor thinking of initiating a carry trade should line up all the macro ducks they can- twin surpluses (ie current acct and budget), purchasing price parity vs spot, GDP growth- etc. They should also manage risk by calculating the effects of exchange rate swings on the potential position, and potentially taking out insurance. A carry trade is truly a longer-term trade, as you need to hold the position for lengthy periods to maximize the interest return. However, this also increases your exposure to the drift in the exchange rate (as opposed to just the volatility). Also, there is a small but non-zero chance of a central bank devaluing a currency (eg Mexico or one of the Central and Eastern Europe (CEE) countries).

The carry trade may very well be one of the winning strategies in the next several years. Many of the higher yielding currencies-especially in the Emerging Markets (EM)-are set to appreciate more than the funding currencies of the majors ($, CHF, JPY).

Paul Stafford writes a weekly Currency Briefing, which covers fundamentals and sentiment measures for the major currencies. If you are interested in receiving it, please visit www.4xtradertools.com

Roth, the chairman of the Swiss National Bank (SNB) declared back in March of this year that the CHF had risen too high against their trading partners in the rest of Europe (the EU25 constitutes 62% of their export market), imperiling their Current Account balance. The SNB actively intervened; selling Swiss francs and buying Euros to maintain 1.51 or so. You can see the initial effect (EUR appreciating against CHF), and the resulting tight trading band (+/- 150 pips) in the succeeding 6 months.

Another example is the $/JPY. The Japanese economy is export-driven, and their largest trading partner is the US (22% of the total). The BoJ is famous for actively intervening in the markets. You can see from this chart the level at which they get rather uncomfortable- about 88 or so. They actively intervened back in February. I am not sure about in October, but it certainly was a good level from which to be bullish.

Trichet has made many comments recently about the TWI (trade-weighted) strength of the Euro, and the weakness of the dollar. While the ECB is not likely to intervene, I imagine that any approach to the previous high of 1.60 will be met with a lot of jawboning.

While trading limits like $/JPY of 88 can be done with the spot, options offer alternatives when the spot exhibits very low volatility like the EUR/CHF. You can actually profit from no movement at all with spread structures, and very limited downside risk. The topic is beyond the scope of this article, but you can reach me at stafford.paul1@gmail.com.

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