A redeeming argument for the carry trade

By John Authers

Published: January 29 2011 03:51 | Last updated: January 29 2011 03:51

The carry trade gets a bad press. It created one of the biggest bubbles of the last decade. But, handled differently, could
it help bring the world’s deep economic imbalances back into kilter?

Simply defined, a carry trade involves borrowing at cheap rates and parking it somewhere with higher rates. In the
jargon, this gives a positive “carry”.

In the 2000s, the most popular carry trade involved the yen, as Japanese interest rates were virtually zero. Investors
could borrow in yen and put the money in a currency with higher rates, notably the Australian dollar. This was a great,
low-risk trade; unless the currencies went into reverse. If the yen suddenly gained on the Aussie dollar, you could soon
lose a lot of money.

This did not happen for many years because the carry trade tends to be self-fulfilling. Selling the yen tended to weaken
it; buying into the Aussie dollar tended to strengthen it. As the carry trade’s profits are quite small, it was only
worthwhile if investors used borrowed money to do it. So the trade carried on making money until disaster struck in the
wake of the Lehman Brothers bankruptcy. Carry traders suffered losses of as much as 30 per cent in a matter of weeks
and the chaos of sharply shifting exchange rates contributed to the calamitous fall in global trade.

Financial commentators (this one included) therefore attacked carry trading as a dangerous form of speculation that
destabilised financial markets and economies.

But there is an alternative argument. Neil Record, who runs Record Currency Management in London, suggests that the
carry trade can be regarded as an asset class and as an ongoing investment for regular retail investors. He even suggests
that it can help resolve the world’s long-term economic imbalances.

How? Countries running a deficit need to raise funds but they are also riskier than those running a surplus. Their risk is
encapsulated by the exchange rate – if the government’s fiscal management breaks down, that will show up in a weaker
currency.

If there is extra risk, investors need to be offered an extra premium in order to take that risk. That is the extra interest
rate on offer in the carry trade. This extra interest rate then becomes the key to working out how to treat currencies like
other investment assets. Currency trades have equal and opposite winners and losers; it is not always at all clear which
of two currencies is more risky.

If this theory works, over the very long term carry trade currencies should outperform others, just as stocks outperform
bonds, thanks to the risk premium investors demand before investing in them.

To test the theory, Mr Record had FTSE set up an index that took a range of currency pairs (the different permutations
available between dollar, the euro, the pound sterling, the Japanese yen and the Swiss franc, such as the dollar-sterling,
the euro-yen and so on) and systematically bought whichever currency in these pairs had the higher nominal interest
rate. It reviews these pairs once a month and switches currencies if the country with the higher interest rate has
changed – although this generally happens only once every few years for most pairs.

The results are shown in the chart – as theory predicted, the carry trade performed nicely over time, with less volatility
than stocks. It has worked less well since the crash of 2008 but still has decent returns combined with lower volatility. An
index with more currencies did better.

A strategy of buying into this strategy and waiting, therefore, does make sense. If investors worked this way en masse,
the currency market would become a mechanism for easing world imbalances.
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Now for the caveats. Mr Record suggests patient “buy and hold” investing with real money, rather than with borrowed
funds. That is different from the opportunistic, leveraged approach to carry trading today. His research does not back
the increasingly popular practice of retail trading in foreign exchange using leverage.

To grasp how extreme that activity is, note that in 2007-10 the Bank of International Settlements found that total daily
foreign exchange trading volume was $3,980bn (or, as people not subject to the Financial Times’s style book would say,
almost $4 trillion). Annual volume is about a quadrillion dollars ($1,000,000,000,000,000). Daily forex trading volume in
London, the centre for such activity, is 140 times that of the London Stock Exchange. That is evidence of speculative,
leveraged investing. Rather than exploit a recognisable anomaly as Mr Record’s strategy does, it distorts markets and
makes it harder for economies to function.

Treated in the way, Mr Record suggests, foreign exchange has some of the facets of an asset class, and might be an
interesting addition to a portfolio. But is it an argument to lever up and try to play the forex market? No. A quadrillion
times no.