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Tuesday, March 1, 2011

Carry trades

With Central banks around the world scrambling to fight commodity price driven inflation, it is a good time to review an old FX trading strategy.

Carry trade is a trade in which a speculator borrows money in a country (and currency) that has a low interest rate and invests it in another country that has a high rate.

Current rates show that an investor could borrow in Japan at 0.1% per year and lend in Brazil at 11.25%.

What should happen?  Interest rate parity suggests that our investor would not benefit because the  the difference in interest rates between two countries should equal the rate at which investors expect the YEN to rise against the BRL.

What has happened?

According to Bloomberg, in 2010, the carry trade of borrowing in dollars and selling the greenback to buy the currencies of Australia, Norway, New Zealand and Brazil returned 11.5 %. That compares with a loss of 2.8 percent using the yen as a so-called funding currency. Interestingly these results have reversed in 2011, with carry trades using the yen gaining 23.8 percent, compared with 2.8 percent in dollar-funded trades.

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