The constant reshuffling of currency exchange rates, the plummet of the yields in the Eurozone (after the resolution of the Euro currency crisis), and the relative weakness of international markets has had a number of effects. American investors have focused on the negative impact of diversification on their portfolios. Corporate America has been focused on the strong US dollar’s impact on US exports, now less competitive on the world market. Under the surface of tangible economic activity - the exchange of goods and services - the flux in relative strength between the US and the rest of the world leads to all sorts of interesting financial activity and international capital flows.
We’re going to delve into a hypothetical, fantasy world for a moment. Alex is an ordinary US investor. Alex finds two local banks who offer very different savings rates for deposits and interest rates for his borrowing needs. A couple of years ago, both banks were offering roughly identical savings rates—about 2%— but that significantly changed by March of 2015. Bank A now offers savings rates of 2.13%. However, Bank B’s savings rates have dropped to almost nothing—0.15%—and similarly low interest rates for borrowing money from the bank.
Alex gets an idea: I will borrow a million dollars from Bank B with the agreement to pay them back in 10 years, plus interest. I will have to pay some transaction fees and Bank B’s very low interest rates. I will invest the million dollars into Bank A, earning their much higher savings rate. Even when I pay back the interest of the million dollars to Bank B, I should keep earning 2% on a million dollars—$20,000 per year for ten years—in a riskless transaction.
That’s the core idea of a carry trade. It’s an arbitrage play on money where I can borrow cash cheaply in one market and get a better return in a different market.
It’s a little more complicated. Let’s add in a real-world fact to the model: carry trades don’t usually take place between different retail banks, but rather between different currencies. In this example, rename Bank A as “10 year US Treasury bonds” and rename Bank B “10 year German Treasury Bonds”, and you’re getting closer to the truth. So, Alex borrows cheap German Bonds—which really did hit the incredibly low yield of 0.15% this week—and invests in US T-Bills, which are actually trading around 2.13%.
As we start adding more facts to our hypothetical example, we start to uncover real-world reasons a carry trade is definitely not riskless. Most notably, the exchange rates between the Euro and the US dollar change constantly. In fact, the dollar has appreciated about 30% versus the Euro just in the past 12 months. If Alex has a whole bunch of extra dollars as a result of the carry trade, but the Euro appreciates from its current low, then he won’t be able to get enough Euros for his dollars to pay back his million dollar loan.