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Though a lot of people like to make this sound complicated, it’s not. Even though the mechanics of carry trades are pretty simple the results might not be.

What is a carry trade?

1. Borrow the low cost currency i.e. low interest rate currency
2. Covert the borrowed currency into a currency that is giving a high yield.
3. Reinvest into:
   • • Deposits of other high yielding currencies
     • Stocks
     • Bonds
     • Commodities
     • Real Estate
     • Derivatives

The currency you borrow in step one is called your “carry trade currency”, some people call it the funding currency. That’s because this borrowed currency gives you the funds to reinvest in other areas. So keep in mind that “carry” and “funding” currency is often used interchangeably in financial literature.

Simple process, why was it, so popular? The reason is because it was profitable. It’s very enticing to be able to borrow inexpensively, reinvest and immediately achieve a much higher return. There’s lots of money to be made due to the difference in cost of funds versa return on funds.

That’s how the theory goes, but it is not always that simple.

For example, say you borrow at 1% then turn around and reinvest the proceeds at 6.5%. You’ve just earned yourself a quick 5.5% return without much work. This of course assumes the asset yielding 6.5% in this example holds its value. If the asset you buy with the carry proceeds falls in value, you have a capital loss. Thus it eats away at the margin so things don’t look so good.

In fact, this is where the problem comes in with the carry trade - it’s based on simplistic assumptions. But incredibly, these simple assumptions didn’t stop fund managers and institutions across the globe from borrowing trillions of dollars to reinvest those assets. And they added massive leverage to boot.

You need to have three major criteria (which are assumptions when projected into the future) for the carry trade to grow into any significance:

1. Low borrowing rates from a major central bank - as highlighted above, it comes down to perceived profitability of borrowing cheap and buying or lending at higher rates to achieve the spread. But for a global carry trade to generate any sort of interest from the big global players there must be a major global central bank behind the trade (Bank of England, European Central Bank, Bank of Japan, etc.). For example, if the central Bank of Zimbabwe were offering 0.5% interest rates, they could not realistically produce enough loans to make it significant. Not to mention they have absolutely no credibility when it comes to monetary policy and a stable currency.

2. Low volatility or weakness in funding currency - if the currency you borrow drops in value to other currencies then you win more, if it stays the same you should be ok, but if it goes up in value then you have a problem. It can quickly wipe out all your profits and you end up losing.

3. Low volatility or strength in invested asset class - As long as the asset class you bought e.g. other currencies, stocks, bonds, etc. with the borrowed proceeds increase in value faster than the underlying borrowed currency, the trade is profitable. But if the assets you bought start to decline in value on a relative basis, your losses can mount quickly.

So there you have it. It’s a straightforward process.

Of course if a lot of big investors and institutions put billions and even trillions into this type of investment. So when we have major market disruptions like we have just experienced then watch out.

Something simple becomes simply devastating for all of us.

Of course when one takes into account leveraging, the means by which a lot of these” high flyers” increase profits for their investors, when things go wrong it means much bigger losses.