The Carry Trade’s base definition and function is governed by macro economic and monetary policy. Over the last decade we have seen a heightened interest in the carry trade technique due to the consistency of returns and the wide interest rate gap between countries. Defined as the “borrowing of one low yielding currency, and investing in a higher yielding pair”, the carry trade allows investors to play the interest rate differential between two economies. An example of the carry trade in its purest form was the dollar yen prior to the global financial crisis. Traders focused on extracting the monetary yield, between the US and Japan at the time. Although the carry trade has become an attractive option for many investors and traders, there are a number of key risks which must be observed. The benefits and risks associated are highlighted in the below section.

Benefits
As discussed in the previous paragraph, the carry trade has grown in interest over the last decade due to fluctuating world monetary policy. The key benefits of the Carry Trade include:

• Cheaper Borrowing costs – sourcing currency from low yield economies

• Flexibility of Investment Yield Choice – investors are able to look at investing the borrowed currency in a range of higher interest rate currencies

• Ability to leverage on borrowings – Investors can leverage with foreign exchange and hence are able to borrow more currency at a lower interest rate and invest or lend at a higher rate.

The benefits of the Carry Trade also extend to market movements and positive fluctuations. As more interest in the Carry Trade for a specific currency grows, the more inflated the price can become, with traders also benefiting from the shift in price. This however can work in both ways, with movements exacerbated during economic devaluation or weakness.

Risks
The risks associated with the Carry Trade can be quite significant. The recent global financial crisis is an example of the dangers of the carry trade with the drop in US monetary policy pushing the yield margin between the greenback and its currency counterparts to record low levels. Economists have noted that the prominent US Dollar Japanese Yen carry trade no longer exists due to the economic environment. Some blame this for the recent appreciation in the Yen against the greenback. The key risks of the Carry Trade include:

• Interest rate policy shift – Weakening of monetary policy due to economic concerns can lower the yield return without lowering the overall risk.

• Price movement adversity – Traders can lose on the carry trade if the price goes against them. The yield in many cases can then not cover the overall lose in the price shift.

• Government intervention – Central Banks can intervene from a liquidity point of view in the currency markets. This can have a dramatic impact on price and sentiment. The Carry Trade’s attractiveness can change dramatically impacting the risk of the trade.

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