You probably have heard the carry trade most often associated with the currency market. This strategy is not just for the big banks and institutional players. Futures contracts make it relatively simple for individual investors and traders to capitalize on the carry trade, and there are some interesting carry trade opportunities right now.
The basic concept of the cost-of-carry involves the cost or benefit of holding a trade, which applies to every futures market. The currency carry trade involves taking advantage of interest rate differences (that is, borrowing costs) between various countries. Each country’s central bank sets a key short-term interest rate target, which can differ greatly. Investors or traders will borrow currency at a lower rate, convert to a currency yielding a higher rate, and then lend it. To unwind the trade, they would convert the currency back. Traders around the world execute this strategy in a variety of ways to capture interest rate differential between economies. This causes cash to flow from economies with low interest rates into economies with higher rates, and that is what’s known as the currency carry trade.
The Japanese yen carry trade is probably the most familiar to investors. For about 15 years, the yen/U.S. dollar carry trade was perhaps the most popular carry trade strategy. Hovering near zero for over a decade, Japan’s interest rates were the lowest in the developed world. When U.S. interest rates fell to near zero, the Japanese yen carry trade began to evaporate. Trillions of dollars had moved out of the Japanese economy and into the U.S. through this trade, causing the yen to trade at artificially low in values. Remember, when traders borrow those yen, they are effectively placing sell orders on the Japanese currency to convert them to U.S. dollars.
So as the rate has narrowed between the two counties and the carry trade has disappeared, the yen has been climbing. The green line in the chart below is the Japanese yen exchange rate. The white line represents the key U.S. short-term interest rate (the Federal Funds rate). The orange line is the Bank of Japan’s key short-term lending rate. You can see how the yen increased in value as the interest rate differential narrowed and cash was repatriated into the Japanese economy. I expect upward pressure on the yen until the differential returns.
This strategy is not without risk. The most serious risk when you borrow money in one currency, convert it into another currency and then lend it in the higher rate currency is that the exchange rate will change to your detriment. For example, if you borrow yen, convert the currency into U.S. dollars, and then lend them at a higher U.S. interest rate, your risk is that the value of the yen will increase. That’s because you will have to reconvert U.S. dollars back to yen to unwind the trade. You might not have enough cash to pay out the loan if the currency appreciates too much. So you need both interest rates, and the currency’s value, working in your favor.
You can see how this trade makes sense for large banks which can borrow and lend currencies in a large scale. But the futures markets allow individual investors and traders to execute this strategy also in a more simple and straightforward transaction. The concept is based on what’s called the law of one price. In efficient markets, identical goods or investments must have a single price. Alternatively, portfolios with identical risk and reward exposures should be priced equally.
You can create the yen carry trade position mentioned in the example above by going short (selling) a Japanese yen futures contract. With this position, you are inherently long the U.S. dollar without actually borrowing or lending actual cash, but the futures market prices in the interest rate differential for you.
Examining the term structure of currency futures, you can see how this works. Since the interest rates in the U.S. and Japan are nearly equal, there really is no viable carry trade right now. So let’s look at some other currencies where this strategy can work. First, the Australian dollar.
The Reserve Bank of Australia’s key short-term (overnight) lending rate is at 4.5 percent, a differential of 425 basis points. Looking at various futures contracts out in time, you can see every futures price is successively lower. This lower price corresponds to the interest rate differential. You can establish a long position in the Austrian dollar, and you accumulate rollover interest of 4.37 percent on an annualized basis. Looking next at a chart, you can see at every rollover point, there’s a step-down in the cost of owning Australian dollar futures reflected in the price. It is significant enough to incorporate that interest rate differential into the futures markets, which you can see marked by the red arrow when the March 2010 contract expired and rolled to June 2010.
Looking next at the New Zealand dollar, there is a similar characteristic. The nation’s central bank currently maintains its key short-term interest rate at 3 percent, and the price differentials between the futures contracts are discounted accordingly. The differential between September and December is about 80 basis points, or 3.20 percent on an annualized basis. You might wonder why the differential is 3.60 percent in September 2011. That’s because the futures markets are pricing in no changes in interest rates in the United States until the end of 2011, while the market anticipates interest rate hikes in New Zealand. That means the interest rate differential today will likely expand over the upcoming year and the futures markets are pricing in a carry of 3.6 percent on the position.
In Canada, the key short-term interest rate is at 0.75 percent, and the annualized rate reflected in these futures contracts is about 90 basis points over the next 12 months. Interest rates in Canada are also likely to expand versus the U.S.
The carry trade concept gets really interesting when you look at a country with a much higher interest rate, such as Brazil. In Brazil, the central bank’s target rate is 10.75 percent—a huge differential versus the U.S. rate. There are about 188 basis points of difference in just three months, and over 12 months, 8.39 percent. You might expect that differential to be even higher. That means the market might be expecting Brazilian interest rates to come down a bit. Or, this data might reflect the fact that this futures contract isn’t highly liquid. You can see how traders and investors have a great opportunity to take advantage of the differential by buying Brazilian real futures and rolling them as they come down to cheaper levels when each futures contract month expires.
With the typical carry trade, you not only have to get the direction of the currency’s price correct, but you also have to get the direction of interest rates correct. When you get widening differentials, the market has incentives to push the currency higher. The real has been climbing upward due to the increased carry trade, and therefore this market has good characteristics for a carry trade. Of all the carry trade possibilities mentioned, I think Brazil offers the most potential right now. Brazil is well positioned to take advantage of shifts in global economics. It is rich in natural resources, its productive capacity has great potential for gains, its debt is reasonable, and it is more open to capital investment. The emerging market in general has further to grow than well-developed countries and this all supports the Brazilian carry trade.
If you aren’t entirely clear on the mechanics of the carry trade, what these various figures mean or how to manage your positions, I encourage you to work with a professional. While it sounds relatively simple, carry trades can involve significant risk. Please feel free to call me to discuss strategies that might be appropriate for your unique goals and risk tolerance.
Aaron Fennell is a Senior Market Strategist based in Lind-Waldock’s Toronto office, and is serving clients in Canada. If you would like to learn more about futures trading you can contact him at 877-840-5333, or via email at afennell@lind-waldock.com.
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