Friday, October 10, 2008

End of the Carry Trade

The carry trade is a bet where you borrow at low interest rates and lend at high rates. Typically, you borrow in Japan and invest in Australia. Your bet is that the interest differentials are not signaling that the Yen will strengthen relative to the weaker currency. For long periods you make small gains. Iceland seemed to be operating as a huge carry trade hedge fund.

It seems now, however, that the carry trade may be ending. The Yen is strengthening in the wake of the crisis. Notice that the carry trade is a bet that markets are not efficient -- that interest parity will not hold. For long periods of time it seems that one can make money going against this. But eventually the reckoning occurs. The problem with such bets is that when they unravel it is a very hard landing.

The carry trade was very profitable for years prior to the Asian crisis. But it unwound quickly and caused large losses when the Yen did appreciate. I wonder if the current unwinding will spread the pain now.

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