So now I’m intrigued by carry trades. Since I’m not a finance specialist, I decided to start by trying to understand the mechanics of carry trades. Jayanth Varma, professor at the Indian Institute of Management, has a concise explanation of the yen carry trade here. I found this a bit difficult to follow, so I constructed the following a sequence of diagrams showing how they work. Varma was kind enough to alert me to some errors in the original diagrams, and I have attempted to revise them accordingly. Of course, any remaining errors are mine. Please let me know if you find any mistakes.
Step 1: Sell yen, buy dollars. Now the fund is short yen and long dollars.
Step 1
Step 2: Swap future yen for future dollars. The swap is a two stage transaction in which the fund (a) receives current yen in exchange for current dollars, canceling out step 1, and (b) receives future dollars in exchange for future yen. Essentially, the swap borrows yen and lends dollars. The terms of the swap incorporate the interest rate that the fund must pay to borrow yen for the period of the swap (r¥ in the diagram) and the interest rate that the fund receives for lending dollars (r$ in the diagram). Presumably r¥ is less than r$, since that is the motivation for the carry trade.
Step 2
Step 3: Invest in mid or long-term U.S. treasuries. Now the fund is short future yen, long future dollars, short present dollars (since it just bought treasuries), and long U.S. treasuries. The treasuries pay an interest rT
Step 3
Step 4: Use the repurchase market to borrow dollars against the U.S. treasuries, canceling out the fund’s short dollar position. This borrowing occurs at the prevailing interest rate in the repurchase market (the “repo rate”, rR in the diagram).
Step 4
Now, with the trade in place, the fund profits from the carry. As far as I understand it, the carry is approximately the difference between the interest that the fund receives on its lending (dollars to its swap contract counterparty and dollars to the U.S. Treasury), which totals (r$ + rT) and the interest rate that it pays to borrow (r¥ + rR). If interest rate spreads are substantial and the fund is highly leveraged, this could be a lot of money. There are a lot of moving parts here, so if I’ve got anything wrong, please let me know.
So where does the risk come from?
First, as I understand it, this is a highly leveraged transaction: the fund as taken on lot of risk without committing any capital. Presumably there are some capital requirements for currency swaps. If anyone understands the factors that limit leverage in these transactions, please let me know.
Second, the fund can get in a lot of trouble if the carry trade currency (the yen, in the above example) or the risky assets (U.S. Treasury securities in the example) depreciate, since the fund will then be left with decreased assets (the treasury holdings) and increased liabilities (the commitment to deliver dollars, which are now more costly relative to the yen). What makes this particularly risky is that interest rate movements could cause both to happen at once: if interest rates rise in the target currency market, the value of the currency will tend to rise and the value of risky assets will fall. Referring back to the above example, consider what happens if the U.S. raises interest rates to reign in speculation: the dollar appreciates, and the value of long-term treasury securities declines.
To make matters worse, carry trades are not regulated, so we don’t know how much risk is out there. Varma highlights the difficulties in measuring carry trades:
since derivative markets are off balance sheet transactions, we would not see the carry trade at all until we break the transactions up into their pieces and start looking at the right places for evidence of the trades.