Carry trade is a means of trading where an investor borrows money from a financial institution then invests the same in assets with the hope of getting a profit from the assets. This means of trading is popular in the foreign exchange market. It involves borrowing from low-interest rate currency then converting that currency into that of a high yielding one. There are two ways in which an investor can earn for the carry trade. One can either invest in a high yielding currency or invest in an asset that has prospects of increasing its worth. These assets can be commodities, stocks, real estate and bonds among others. These assets must be in the denomination of the second currency.
Carry trade between Japan and Australia
Carry trade between Japan and Australia involved using Japan's currency to purchase Australia's assets. Japan's currency has been offering a near zero percent interest rate making it a favorable currency trade option in many countries including Australia. Investors were borrowing Japan's currency at zero percent interest rate then converting it to Australian dollars to purchase Australian assets. Japan's yen has been in all time down, and the current government is working to push it further down. Many investors have been using the Yen to purchase Australian dollar securities without even hedging it to increase the profits. Investors are targeting the short-term securities with periods of three months.
Potential risks and dangers
There are two major risks associated with carry trade. One, investors suffer from a sharp and sudden decrease in asset prices. There is also the potential for implicit loss due to the difference between the funding currency and the investor's domestic currency.
Japan’s bonds are trading in the negative territory for ten years. If an investor were to wait for the Japan’s bonds to mature, they would lose some of their cash.
Buying assets using Japanese Yen as the source funds and Australian dollars as the domestic funds without hedging puts the investor at a risk of loss if the Australian currency deeps against the Japanese yen.
Another risk involving this trade is when the property values depreciate after investors have purchased the assets using the source currency. This scenario may occur when there is too much speculation leading to many investors to focus on a particular investment. It the properties fails to mature to the investors' expectation which happens most of the times, the investors are left stranded with their properties that begin to depreciate. Investors are left with the burden of paying back loans with interests.
Japan’s currency also has risks of rapid appreciation as was the case in 2008. When a currency appreciates, investors get compelled to change their assets into that currency. This situation puts the investors under pressure to cover their debts and causes an accelerating effect on carry trade valuation changes. Such a situation would eventually lead to financial pressure on the part of the investors.
The Reserve Bank of Australia (RSB) has put carry trade at risk by cutting down the interest rates. The Australian dollar was popular as it gave the Yen investors leverage due to high-interest rate. Cutting down the interest rates means that the investors can no longer take substantial risks since they are more than likely to lose money.
