Carry trade explained Since this has been a popular topic recently, I figure I'd explain it briefly on how the trading mechanism works.
First of all, this is a type of arbitrage play but not a true arbitrage transaction. For instance, i simultaneously buy and sell the same product at the same at a profit. This is effectively viewed as a risk free transaction because there is no duration risk. The carry trade has duration risk.
Ok so how does the carry trade work?
For this trade to be effective you need stability in the exchange rate of the currencies involved. Let's say the Yen and the $US. Secondly, there needs to be an arbitrage play where the currency you borrow from (Yen) has a much lower interest rate than the borrowing costs from a second country (US$). In this case the US has a borrowing cost of 5% and the Yen has a borrowing cost of 1%. These numbers have been simplified to illustrate my point. There is a spread of 4% and a nice arbitrage opportunity. You can borrow the Yen, then buy $US and invest in a 3 month t-bill and pocket the spread. However, hedge funds were borrowing in Yen and then going out to buy Nvidia and other high flying stocks for the alpha. The strategy is simple. My borrowing costs are low and it's unlikely the Japanese Yen will appreciate in value anytime soon. Not so fast. The trade went sour when the Yen raised interest rates which pushed the value of the Yen higher and creating a margin call where investors had to sell their investments in the S&P, then close their trade by buying back the Yen and paying off the debt. Since the Yen appreciated relative to the $US, you now required more $US to buy back the Japanese yen to close out the deal. In other words, any gains might have been completely wiped out.
The trade is effective if and only if,
1) you are short the Japanese Yen
2) The money earned from US assets or bonds outweighs the borrowing costs from the Yen.
The trade is not effective if,
1) You were short the Yen but the Yen appreciated
2) The money earned from US assets (potentially negative) is lower than the borrowing costs of the Yen.