Exotic Carry Trade Currencies

By Dan Blystone

Introduction to the Carry Trade

The carry trade, a strategy favored among hedge funds and investment banks, is now growing in popularity among retail forex traders. A number of forex brokers are currently offer trading in exotic currencies such as the Turkish Lira (TRY) and South African Rand (ZAR) yielding strikingly high interest rates. These exotic currencies present a high risk/high reward vehicle for use in a carry trade strategy.

The carry trade is an investment strategy that involves a basic arbitrage between interest rates. In any forex transaction you are simultaneously selling one currency and buying another. In doing so, you are borrowing at one interest rate and investing at another rate. The carry trade involves selling a currency with a low interest rate, then using the proceeds to purchase a currency with a higher interest rate. If you buy the GBP/JPY pair, you are buying the British Pound and selling the Japanese Yen. You collect interest on the currency you buy and pay interest on the currency you sell.

In buying a high interest yielding currency and selling a low yielding currency you capture the interest rate differential. For example if the New Zealand Dollar has an interest rate of 8.25% and the Japanese Yen has an interest rate of 0.5%, an investor buying the NZD and selling the JPY will earn the interest rate differential of 7.75%. This return does not assume any leverage is used. At 5 times leverage the interest would yield 38.75% annually.

Between 2000 and 2007, one of the best carry trade pairs was the NZD/JPY. NZD interest rates have risen dramatically while JPY rates have remained very low. Japan's lending rate of 0.5% is the lowest among industrialized economies. The global commodities bull market and anti-inflation policies of the Reserve Bank of New Zealand have contributed the NZD’s recent historic highs.

Click here to see Figure 1: NZD/JPY Carry Trade (DealBook® 360 screen capture used by permission. © 2008 by Global Forex Trading, Ada MI USA)

The carry trade is normally used as a long term strategy, from 6 months to years, allowing the investor to weather short term market volatility.

The carry trade involves funds flowing from countries with currencies paying low interest rates to countries with high interest yielding currencies. Typically the higher yielding currencies are higher risk investments and are associated with rapidly growing economies. The ideal time to position yourself in a carry trade is at the beginning of a rate-tightening cycle in the currency you are buying.

In a time of crisis such as the terrorist attacks of 9/11/2001, investors seek safe haven currencies such as the Swiss Franc. Times of uncertainty can create an ‘anti-carry’ climate with funds moving away from higher risk currencies.

The three main funding currencies for the carry trade are the US Dollar, the Japanese Yen and the Swiss Franc. The New Zealand Dollar (NZD), Australian Dollar (AUD) and the British Pound (GBP) have been the main recipient currencies of the borrowed funds in recent years.

In the forex market interest payments are made daily based on your position. Your positions are closed out and reopened by your broker daily, a process known as ‘rolling over’. Your account is then debited or credited based on the overnight interest rate differential.

The ability to leverage your position is a key element of the carry trade. The leverage available in the forex market allows you to multiply by many times the interest rate of return. In using leverage the level of risk is also increased exponentially. There of course remains the large risk that currency market moves will erase the profits generated through the interest rate differential.

If for example a terrorist attack took place in London the GBP/JPY could easily fall by 1000 pips. The carry trade has the potential of generating a very high rate of return annually, but that gain (and possibly more) can be wiped out in a day. In order to offset risk in any one pair you can diversify carry trades among many different pairs, creating a carry trade basket.

Yen Carry Trade

The USD/JPY carry trade entered the spotlight when the Yen started trending downwards in 1995. From 1990 to 1995 the Bank of Japan had lowered the official discount rate from 6% to 0.5%., enabling low cost borrowing in the Yen. From 1995 to 1998 the USD/JPY market soared from 80 to 147 Yen per dollar.

An increase in currency volatility was an important element in the unwinding of the USD/JPY carry trade. In 1998 when massive Yen carry trades had built up, the Russian Financial Crisis and the collapse of Long Term Capital Management triggered uncertainty and volatility in the market. Hedge funds scaled back their leveraged positions and the Yen began to appreciate in value.

Click here to see Figure 2: Yen Carry Trade (DealBook® 360 screen capture used by permission. © 2008 by Global Forex Trading, Ada MI USA)

US Dollar as a Carry Trade Funding Currency

Falling US interest rates and increasing volatility in the Yen and the Swiss Franc are making the US dollar a more appealing funding currency. We may begin to see a major movement in borrowing from Yen and Swiss Francs into US dollars, adding further downward pressure to the already beleaguered US currency.

Exotic Carry Trade Currencies

Exotic carry trade currencies yielding enticingly high rates of interest include the Icelandic Krona, Brazilian Real, Turkish Lira, South African Rand, Mexican Peso and the Hungarian Forint.

The most commonly offered of these exotic currencies among retail forex brokers are the Turkish Lira, South African Rand and Mexican Peso. Below we’ll take a look at some of the fundamentals behind these high yielding emerging market currencies.

Turkish Lira (TRY)

The Turkish Lira currently offers the highest interest rate in the industrial world, with the Turkish Central Bank’s benchmark overnight rate standing at 15.25% as of this writing. One of the most popular carry trade strategies of 2007 was to go long TRY/JPY (borrowing Japanese Yen to buy Turkish Lira).

Turkey experienced significant economic gains between 2002 and 2007 in part due to increased foreign investor interest in emerging markets. The robust GDP growth rate during this period placed Turkey among the fastest growing economies in the world. International Monetary Fund (IMF) backed reforms starting in 2001 helped to improve economic stability. In January 2005, with the high inflation rates contained, the old Turkish Lira was replaced by the New Turkish Lira (dropping off six zeros). Prospective EU membership and economic reforms contributed to the rise in foreign investment. However, the Turkish economy is still has to overcome the challenges of a high current account deficit and high level of external debt. The Lira is also threatened by the possibility of political instability and the global credit crisis deterring foreign investment.

Turkey is a founding member of the OECD (Organisation for Economic Co-operation and Development) - an international organisation of thirty countries, that accept the principles of representative democracy and a free market economy. Turkey is also a member of the G20 industrial nations. The G-20 (Group of 20) is a group composed of 19 of the world's largest economies, along with the European Union.

South African Rand (ZAR)

The South African rand (ZAR), is among the world's most actively traded emerging market currencies. The Central Bank of South Africa’s overnight rate stands at 11% as of this writing. The central bank of South Africa, raised interest rates four times last year to to contain inflation and contain consumer spending. South Africa has an abundant supply of natural resources and is another economy to have benefited from the global commodities boom. However, high unemployment, inadequate infrastructure and HIV/AIDS remain challenges yet to be overcome. While economic growth has been strong in recent years, power shortages from state-owned electricity supplier (Eskom) and global economic volatility suggest that real GDP may slow in 2008. The eyes of the world will soon be on South Africa as it hosts the 2010 FIFA World Cup.

Mexican Peso (MXN)

Banco de México’s overnight rate stands at 7.5% for the Peso. Mexico has a free market economy with a Gross Domestic Product surpassing a trillion dollars measured in purchasing power parity. The world’s 13th largest economy, Mexico is an export oriented, and the biggest exporter and importer in Latin America. Oil is the largest source of foreign income. As a result of economic stability and the growth in foreign investment, the Mexican peso is now among the 15 most traded currencies in the world, and is the most traded currency in Latin America. Since the late 1990s the peso has remained stable trading at about $9 to $10 to the U.S. dollar.

While the Federal Reserve is expected to continue lowering interest rates to stimulate the U.S. economy, Mexico's central bank is expected to keeping rates unchanged creating a widening spread between the interest rates (as of this writing).

Conclusion

The daily interest payouts and massive leverage available make the carry trade a fascinating, if high risk opportunity for investors, and a compliment to purely directional trading strategies. Exotic currencies offer further diversification to a traditional basket of carry trade currencies. However, rising inflation, volatile currency markets and uncertainty resulting from the sub prime credit crisis has let to a dangerous level of instability in the markets. The international credit crisis has dampened investors' enthusiasm for riskier emerging markets. The return of an increased risk appetite among investors and diminished market volatility will set the stage for a steadier carry trade environment.