In today's global economy, investment strategies that were once available only to international financial institutions are now open to investors at all levels. While individual investors used to be limited to investments in stocks, mutual funds, and a limited number of fixed-income securities like Treasury bonds and bank certificates of deposit, the universe of possible investments for individual investors now includes everything from commodity futures to options and other derivatives. Even hedge funds that were formerly open only to the wealthiest individual investors are beginning to solicit investments from a wider range of the net-worth spectrum.
Another strategy that's easier for individual investors to use as a result of increased access to global markets is called the currency carry trade. Although the concept behind the strategy is simple, it has been successful for a long time. Yet with economic changes beginning to occur in various regions throughout the world, some commentators are beginning to predict the end of this profitable strategy.
How the carry trade works
The mechanics of the carry trade are relatively straightforward. Currencies around the world are tied to a set of prevailing interest rates that savers can expect to receive for investments denominated in that currency. Borrowers, meanwhile, can expect to pay that rate for loans of the currency. Because countries vary in the ways they monitor or control interest rates for their particular currency, there isn't necessarily any connection among rates in different countries; for the most part, local economic conditions dictate local interest rates, and to the extent that these local economic conditions aren't interrelated, interest rates in different countries tend to move independently of each other.
Using the carry trade strategy involves three separate transactions. First, you must find a country offering loans at a relatively low interest rate and borrow money denominated in that country's currency. Second, you take the foreign currency that you just borrowed and exchange it for the currency of a different country that is offering higher interest rates on investments. Third, once you've made the currency conversion, you then invest your new currency and earn a relatively high rate of interest.
Let's look at how this works in practice. Assume that toward the end of last year, you had borrowed 116,000 Japanese yen. With interest rates on Japanese government bonds having remained close to zero over the past year, you could probably have obtained such a loan with an interest rate of around 1%. Many brokers offer these loans with margin accounts. At the then-prevailing exchange rate of 116 yen to the dollar, you could have exchanged your yen for 1,000 American dollars. Investing those dollars in Treasury bills yielding an average of about 4.5%, you would have earned $45 in interest. You could then take the total of $1,045, convert it at the current exchange rate -- again, 116 yen to the dollar -- and obtain a total of 121,220 yen. After paying 116,000 yen to repay the loan and an additional 1,160 yen in loan interest, you would have 4,060 yen, or $35, remaining as pure profit. If you use higher-yielding securities from agencies such as Fannie Mae (NYSE: FNM ) or Freddie Mac (NYSE: FRE ) , you can potentially make an even larger profit.
Admittedly, $35 isn't a lot of money. However, according to Morningstar, an unnamed Japanese official has estimated the net value of yen-based carry trade transactions at as much as 15 trillion yen, or about $130 billion. If these figures are correct, then profits from the carry trade would be roughly $4.5 billion annually.
Risks of the carry trade
It's important to realize that although the carry trade has worked very well over the past decade, it is not without risks. The key variable in determining whether a particular carry trade strategy will be profitable is what happens to exchange rates during the time the trade is open. If the value of the borrowed currency rises in relation to the value of the invested currency, then one's profits will be reduced or even turn into losses. For instance, using the example described above, if the value of the yen had risen so that you would receive only 110 yen per dollar rather than 116 at the end of the year, then you could get only 114,950 yen in exchange for the $1,045 -- an amount insufficient for you to pay back the full principal due on the loan, let alone the interest.
The success of the carry trade also depends on the continuing disparity among interest rates in various countries. Much of the success of the dollar-yen carry trade strategy is that short-term interest rates are 4%-5% higher in the United States than in Japan. However, the Federal Reserve shows few signs of ending its pause in raising interest rates, and Fed funds futures are starting to factor in the possibility of rate cuts in 2007. Meanwhile, after years of fighting deflationary pressure, Japan may be close to ending its low-interest-rate policy and could begin raising rates in the near future. Both of these factors would combine to narrow the spread between U.S. and Japanese interest rates and thereby reduce the potential profits from the carry trade strategy.
Some commentators have expressed concern that if traders stop using the carry trade strategy, then the recent weakness in the dollar may accelerate. Because investors who execute carry trade strategies buy dollars in exchange for yen, their transactions create demand for the dollar and help to support the exchange rate. Without this support, some observers worry that the dollar would fall dramatically and create a currency crisis of the sort usually associated with developing countries. Whether these consequences actually come about remains to be seen.
The carry trade is one example of how sophisticated investors use global financial markets to seek profits. Although the strategy involves risk, it has rewarded its users significantly over the past several years. But if the success of this strategy is coming to an end, it may have an impact on the earnings of financial institutions that have made substantial use of the carry trade.
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The only Japanese currency play that Fool contributorDan Caplingercurrently has is a 1,000-yen note on his dresser. He doesn't own shares of the companies mentioned in this article. Fannie Mae is an Inside Value pick. The Fool'sdisclosure policyis good all over the world.