You make money by buying low and selling high. That usually is easier said than done, but it hasn’t been difficult recently in international finance. That is changing, however, and this change may affect many who are unfamiliar with “the carry trade.”
This involves borrowing money in a country where interest rates are low and investing it in another country where they are higher. It’s an old business and helps move capital where it is needed. It usually involves substantial risk. That didn’t seem true the last few years. Borrowing in Japan and investing elsewhere seemed a sure thing. Now, however, risk is returning with a vengeance.
The process is simple. Suppose you borrow 115 million yen from some bank. If the exchange rate is 115 yen to the dollar that is a million bucks. The interest rate may be only 1.5 percent a year since the Bank of Japan is keeping rates low. You change the yen into dollars and invest in U.S. money markets that pay 5 percent. At the end of a year you have $1,050,000. You only need $1,015,000 to replay your yen loan, so you have earned a cool $35,000 for some paperwork.
That is only true, however, if you can still get 115 yen for each dollar. If the yen has strengthened – if it now takes fewer yen to buy a dollar — you won’t get as many yen for each dollar. You will need more dollars acquiring the Japanese currency required to pay your loan.
If, for example, a dollar buys only five fewer yen than before – 110 instead of 115, you will need $1,061,136 to repay the 116,725,000 yen you owe in principal and interest. Oops! That’s more than you got cashing in your CDs.
Of course, the yen could go the other way. If it weakens to 120 yen a dollar, you will need only $972,708 to pay your loan. Your profits will be $77,292 instead of $35,000.
The carry trade can be profitable as long as exchange rates don’t move against you. But you are not the only person in this game. When many are borrowing yen and then trading them for dollars, simple supply and demand makes the dollar more valuable and the yen less valuable. It takes more yen to get a dollar.
On the other hand, if everybody is bailing out of the business and selling dollars to get the yen needed to pay off their loans, then the yen becomes worth more and the dollar less. That is precisely what hurts you.
Herd instincts transform fears into a self-fulfilling prophecy, a financial vicious circle. If you are a big hedge fund with a several billion dollars in yen loans, your potential losses are very large. If such a fund is highly leveraged, that is if the loans it must pay are high relative to amount of money in the fund, then you can be in bad trouble quite quickly.
© 2007 Edward Lotterman
Chanarambie Consulting, Inc.