For some people, there's only one thing better than making money in the financial markets: making money using an investing strategy with an impressively sophisticated-sounding name. If that's your primary factor in deciding how you'll invest your money, then you probably don't have to read any further than right here, because the carry trade is right up your alley.
If, however, you're just curious about what this "carry trade" thing is -- or you'd prefer to have some clue what you're investing in before you commit all your free cash to something that sounds like it could have come out of a Bernie Madoff brochure -- then read on. Because like it or not, we're all going to have to get familiar with the carry trade for at least a while.
What the heck is a carry trade?
In the most general terms, a carry trade involves trading something that's either costly to hold, or generates little or no return, for something else that's either cheaper to hold or generates a higher return. The general idea is to make the trade, hold onto the cheaper, higher-returning asset long enough to reap a profit, and then trade it back for your original asset.
Most frequently, the carry trade refers to the currency markets. Because of differing interest rate policies among governments around the world, you can inevitably find some countries where interest rates are low, and others where rates are high. The three steps of the carry trade, therefore, go something like this:
- Borrow money in Country A, where you can get a loan with a low interest rate.
- Exchange the loan proceeds for the currency of Country B, which offers a higher interest rate. Invest it and collect your interest.
- Exchange your money back into Country A currency and repay your loan. Whatever's left over, if anything, is pure profit.
Sounds easy, doesn't it?
For decades, the carry trade almost exclusively involved borrowing Japanese yen, whose interest rates were extremely low. Even with the yen gradually appreciating against the dollar, the interest rate differential was enough to make up for currency losses. Investment banks like Goldman Sachs (NYSE: GS ) are among the large financial institutions that have used the yen carry trade to generate substantial profits over the years.
Now, though, the U.S. is in a much different situation. With interest rates here close to zero, we're the ones whose currency can finance a carry trade.
By borrowing in dollars, converting them to foreign currency, and investing abroad, investors have recently made money two ways. They've been able to invest in booming foreign stocks -- witness shares of companies like Australia's BHP Billiton (NYSE: BHP ) , Brazil's Vale (NYSE: VALE ) , and Mexico's America Movil (NYSE: AMX ) , all of which reside in countries with higher interest rates than the U.S. -- and make strong profits. Yet more importantly, they've also benefited from the fact that contrary to economic theory, the dollar has fallen in value against most foreign currencies, giving investors currency-related profits as well.
The key to the carry trade is that there's a huge amount of risk involved. Right now, everyone seems convinced that the dollar will continue to get weaker, and the carry trade bets on that trend continuing. Yet as we saw last year, the dollar is prone to huge swings in either direction -- and a strengthening dollar could turn carry-traders' profits to big losses. Just as multinational companies like McDonald's (NYSE: MCD ) , Amazon.com (Nasdaq: AMZN ) , and Coca-Cola (NYSE: KO ) tend to suffer from adverse currency impacts on their earnings when the dollar strengthens, so, too, would a stronger dollar wipe out the carry trade.
Being able to go to cocktail parties and brag that you're cleaning up with your carry-trade strategy might sound like the ultimate selling point. For most investors, though, trying to profit from the carry trade is more risk than it's worth. A more prudent way to get some of the same benefits is to take some of the dollars you already have, and buy shares of international stocks. That way, your overall portfolio can benefit, no matter which way the dollar moves in the future.