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Understanding Carry Trades
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ten4one
Master |
27-Nov-2007 13:19
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Good debts are debts that could be serviced without breaking schedule dates. Bad debts are debts that could not be recovered from further repayments. Of course all investments have risks with different scales of rewards. Investing in equity is very much simpler than that of carry trades which requires skills and understanding of global financial markets (interest rates, exch rates, int'l tradings regulations, political risks..etc. Therefore, only the 'professionals' with global connections are able to handle carry trades - huge risks with huge rewards! Cheers! |
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Pinnacle
Master |
27-Nov-2007 11:13
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Another micro level of carry trade... If you have lump sum say $50k and is servicing housing loan of 3% p.a. If you do pre-payment of housing loan, you save on the 3% p.a. but investment in equity or funds can earn up to 10% or more, which is a gain of another 7% more! This is also known as good debts. But ofcourse, investment is not always profitable as risk is involved. |
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ten4one
Master |
27-Nov-2007 09:54
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Don't get carried away and drown under your own weight. It looks simple - just borrow from low int rates and expand them into higher int rate instruements! One strong swing and wrong directional change of currency exchange rates could translate into heavy losses. Cheers! | ||||||||||||||||||||
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Pinnacle
Master |
26-Nov-2007 13:21
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Dollar Displaces Yen, Franc as Favorite for Funding Carry Trade Using the dollar to pay for purchases of currencies with higher yields is proving to be the most profitable trade in the foreign-exchange market. A basket of currencies including the British pound, Brazilian real and Hungarian forint financed with dollars returned 17 percent this year, compared with 9 percent when funded in yen and 7 percent in Swiss francs, according to data compiled by Bloomberg. Falling U.S. interest rates and increasing volatility in the yen and franc are making the trade even more appealing. ``With the dollar giving the appearance of being in free fall, it increases the attractiveness of using the currency to fund investments,'' said Avinash Persaud, chairman of London- based Intelligence Capital Ltd., which advises hedge funds that manage more than $89 billion. ``That process will only add more fuel to the decline.'' The last time the U.S. currency was used for so-called carry trades was in 2004, when the Federal Reserve's target rate for overnight loans between banks was 1 percent, said Niels From, a strategist at Dresdner Kleinwort in Frankfurt. Since then, it has weakened 18 percent on a trade-weighted basis, according to a Fed index. The International Monetary Fund says the dollar made up 64.8 percent of central banks' currency reserves in the second quarter, down from 71 percent in 1999. Investors are borrowing dollars and using the money to buy assets in countries with higher interest rates even though U.S. borrowing costs are 4 percentage points more than the Bank of Japan's and 1.75 percentage points above the Swiss National Bank benchmark. In carry trades, speculators get funds in a country with low borrowing costs and invest in one with higher returns, earning the spread between the two. Housing Slump Speculation against the dollar increased as the worst housing slump since 1991 forced policy makers to cut the benchmark rate twice to keep the economy out of recession. The currency depreciated in five of the past six years leading central bankers from the Arabian Peninsula to China to diversify their reserves and increase holdings of non-U.S. assets. The dollar dropped 1.2 percent last week against the euro to $1.4837, and has weakened 12 percent so far in 2007. The U.S. currency has depreciated 10 percent versus the yen this year, including 2.5 percent last week to 108.35 yen. It fell to a record 1.089 Swiss francs on Nov. 23. Investors may switch more than $100 billion of borrowing from yen or francs into dollars in the next two years for carry trades said Jens Nordvig, a strategist with New York-based Goldman Sachs Group Inc., the biggest U.S. securities firm by market value. Real, Won, Pesos The value of futures contracts held this month by hedge funds and traders betting against the dollar was a record $33.9 billion more than contracts that profit from a gain, according to New York-based Morgan Stanley, the second-biggest U.S. securities firm. Pacific Investment Management Co., which oversees the world's biggest managed bond fund, is selling dollars against the Brazil real, Mexican peso, Korean won and Singapore dollar. ``When we think about currencies on a three- to five-year basis we're very bullish on emerging markets versus the U.S. dollar,'' said Andrew Balls, who helps manage $80 billion for Newport, California-based Pimco. ``That view is only reinforced when you look at interest-rate differentials.'' The real rose 18.5 percent this year and Singapore's currency strengthened 6.4 percent, while the won was little changed. The Mexican peso fell 1.4 percent, the only one of the 16 most-traded currencies to do worse in the foreign exchange market. Interest Rates Pimco, a unit of Munich-based insurer Allianz SE, expects the Fed to lower borrowing costs to around 3 percent, from 4.5 percent. Policy makers have reduced the rate by 0.75 percentage point since Sept. 18. Interest-rate futures on the Chicago Board of Trade show investors see a 58 percent probability that the U.S. benchmark will drop to 3.75 percent by March 31. Switzerland's key rate is 2.75 percent and Japan's is 0.5 percent. The dollar produced a positive carry, the combined gain from the difference between interest rates and changes in foreign exchange, against 20 of the 24 most actively traded emerging market currencies this year, Bloomberg data show. The franc was positive against 12 and the yen versus 14. Using a currency to finance bets can drive down its value. Former Japanese vice finance minister Hiroshi Watanabe said in May that one reason the yen had fallen to a record low against the euro was because it was funding about $500 billion of carry trades. Attracting Speculators The dollar attracted speculators when the Fed cut the target rate from 6.5 percent in 2001 to 1 percent in June 2003 and kept it there for a year, said Dresdner Kleinwort's From. When the Fed started to raise borrowing costs, traders fled. The U.S. rate surpassed the European Central Bank's benchmark in December 2004, helping the dollar gain almost 13 percent versus the euro the following year. Strategists say the U.S. currency will recover because the economy is adding jobs and producing faster inflation, limiting the Fed from reducing borrowing costs. The dollar will rebound to $1.42 per euro and to 113 yen by the end of June, according to the median forecast of 41 analysts surveyed by Bloomberg. The Fed will probably cut its target a quarter-point to 4.25 percent in the next three months and leave it there through 2008, according to a separate survey from Nov. 1 to Nov. 8. The U.S. economy will accelerate to a 2 percent annual growth rate next quarter, from the current 1.5 percent, the survey showed. ``We're actually bullish the U.S. dollar,'' said Jack McIntyre, who helps manage $25 billion at Brandywine Global Investment Management LLC in Philadelphia. ``As long as the world doesn't fall off a cliff, we will see people continue to play the carry trades and the yen will be the premier funding currency.'' `Safer Source' The dollar is becoming more attractive for speculators concerned that higher volatility will reduce profits from bets funded in yen. An increase in price swings dents returns by raising the risk that gains from the spread between interest rates will be erased by foreign-exchange losses. The yen appreciated 8.7 percent against the dollar since Oct. 15 as implied volatility on one-month dollar-yen options climbed to 14.97 percent from 7.47 percent. Dealers quote implied volatility, a gauge of expectations for currency moves. ``The dollar becomes a safer source of funding'' as volatility rises, said Maxime Tessier, head of foreign exchange in Montreal at Caisse de Depot et Placement, which manages $151 billion. |
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Pinnacle
Master |
25-Nov-2007 18:53
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FSM - Carry Trades - How Do They Affect Markets During Volatile Times? What Are Carry Trades? Carry Trades normally refer to currency carry trades. Investors borrow money with a low interest and then invest them into higher-yielding financial instruments. For example, an investor borrows 1000 yen from a Japanese bank. He converts this 1000 yen into USD and invests the amount into a government bond. Assuming the bond pays an interest of 4.75% and the cost of borrowing Japanese yen is just 0.5%, the investor can make a profit of 4.25%, provided that the exchange rate between the USD and the Japanese yen remains unchanged. However, if the USD were to depreciate against the Japanese yen, then the investor may risk incurring a loss since he has to pay back a more expensive currency (yen) with a less valuable currency (USD). Why Carry Trade? The benefit of carry trades is that investors can increase their return by using the principle of leverage. For example, if an investor has 1000 yen in his pocket, he can leverage his investment ten-fold by borrowing an additional 10,000 yen. He converts the yen into the USD and buys US Bond for the equivalent amount. He is now enjoying an interest rate of 4.25% and the return from the investment will be 42.5% (4.25% * 10). Among the G7 countries, the benchmark interest rate in Japan and Switzerland are the lowest. The Japanese yen and the Swiss franc provides an accommodative environment for carry trades to take place. In contrast to the low interest rates in Japan and Switzerland, the yield spread between these 2 countries and other high-yield countries is quite significant. This is the major reason why carry trades have been extremely prevalent in the last few years. Table 1: Interest Rate Comparison
Source: Bloomberg
Carry trades can help to boost the global equity markets, by providing liquidity to the equity markets all over the world. Investors will make good use of this opportunity to leverage their investment positions. Compared to bonds, equity markets will normally deliver a higher return. As a result, many carry trade participants will invest their "cheap money" into the equity markets. A larger proportion would invest into emerging market equities as the potential return from these markets is higher. Carry trades can help to boost the equity markets, but what is the drawback of carry trades?
The drawback of increasing volumes of carry trades is the increase in market volatility. During global market slumps or corrections, investor confidence is affected. Creditors who lend their money to the investors for carry trades will start to worry about the ability of their debtors to repay their debts. In order to minimise their risk, they will ask their debtors for immediate repayment. As mentioned above, these debtors often invest the money they borrow into the equity markets. If they were asked to repay back the principal amount to the creditor, they would be forced to liquidate their equity positions. Hence, the markets will face a greater slump because many investors are forced to liquidate their positions. Carry trade investors may lose money when they liquidate their position. However, this is not the end of the story. Let's assume investors borrow in Japanese yen to execute their carry trades. When there is a market slump, these investors in the market would liquidate their stock positions in order to repay back the amount they borrowed from their creditors. The demand for the Japanese yen goes up sharply and drives the yen to appreciate against all other high-yielding currencies. When this situation occurs, investors are not only incurring a loss from liquidating his position, but also incurring a loss from foreign exchange when they convert their monies back into the Japanese yen for principal repayment. Bond Funds Act As A Portfolio Stabiliser Carry trades can help to improve market liquidity and facilitate the growth of the equity markets. However, investors should be aware that it would also increase market volatility. Higher levels of market volatility lead to higher risks for your investments. We recommend investors to hold a diversified portfolio and rebalance on a yearly basis in order to avoid too much exposure to any one specific market that might have risen significantly during the year. A bond fund can also act as a stabiliser in a portfolio because bond funds normally have a low correlation with equity funds. |
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