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Carry Trade - Global Finance

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Carry Trade
INTB 693W – Global Finance

A carry trade is a strategy in which an investor borrows money at a low interest rate in order to invest in an asset that is likely to provide a higher return. This strategy is very common in the foreign exchange market. For example, in the period up to 2007 many investors borrowed in Japanese yen or Swiss francs, taking advantage of very low interest rates in Japan and Switzerland, and used the money to take long positions in currencies backed by high interest rates, such as the Australian and New Zealand dollars and South African rand. Historically, carry trade always resulted in excess returns on an average, while being occasionally subjected to large downside risk.
In the past few years, the profitability of the traditional currency carry trades has declined as the central banks of major developed countries have pursued quantitative easing policies that are designed to keep interest rates low. Opportunities for currency carry trades do, however, continue to exist in the emerging markets.
In the carry trade, there are three important sources of risk. Some economists believe that the high interest rates paid on emerging market currencies could be due to hidden disastrous events that had not yet occurred. Another type of risk relates to contagious crises in emerging markets. Because many of the players in the carry trade are present in all of the emerging market currencies, a crisis in one currency can carry over and cause additional chaos in other markets. The final type of risk that carry traders should be aware of is the exposure of the trade to a financial crisis in the developed markets. During the global financial crisis of 2008, the carry trades were hit very hard. This was not because these markets were the source of the crisis, since the source could clearly be found in the housing market, but because traders...

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