What is a Carry Trade?

A carry trade is a strategy that involves borrowing in a currency with a low interest rate and investing in a currency with a high interest rate. The goal is to profit from the difference in these interest rates, often referred to as the interest rate differential or carry. It's essentially leveraging cheaper money to buy higher-yielding money.

Strategy: If you can borrow money at 1% interest and lend it out at 4% interest, you're netting a 3% profit. The same principle applies in currencies.

The Mechanics: USD/JPY as Our Example

• The Japanese Yen (JPY): The Funding Currency
  For a long time, Japan has maintained very low, even negative, interest rates as part of its monetary policy to stimulate its economy. This makes the Yen an attractive funding currency for carry trades. You can borrow Yen relatively cheaply.
• The US Dollar (USD): The Investment Currency
  In contrast, the United States, at various times, has had higher interest rates compared to Japan. This makes the US Dollar an appealing investment currency for a carry trade. You can invest in USD-denominated assets (like US Treasury bonds or even just holding USD in an interest-bearing account) and earn a higher yield.

The Carry Trade in Action:

1. Borrow JPY: A trader or investor would borrow a certain amount of Japanese Yen. Let's say they borrow 100 million JPY at an annual interest rate of 0.1%.
2. Convert to USD: They then immediately convert this borrowed JPY into US Dollars at the prevailing exchange rate.
3. Invest in USD Assets: They invest the converted USD into a US Dollar-denominated asset that offers a higher interest rate. Let's assume they can earn 3.5% on their USD investment.
4. Pocket the Difference: Over a year, they would earn 3.5% on their USD investment while paying only 0.1% on their JPY borrowing. This leaves them with a theoretical profit of 3.4% (3.5% - 0.1%), assuming the exchange rate remains stable.

Warren Buffet's Carry-Like Play

While not a pure currency carry trade in the traditional sense, Warren Buffett's significant investments in Japanese trading houses showcase a similar underlying principle.

Starting in 2019 and becoming widely known in 2020, Berkshire Hathaway, led by Buffett, began acquiring stakes in Japan's five largest general trading companies: Itochu, Marubeni, Mitsubishi Corp., Mitsui & Co., and Sumitomo Corp.

Here's where the carry element comes in:

• Cheap Funding: Berkshire Hathaway strategically issued yen-denominated bonds in Japan. With Japan's ultra-low interest rate environment, these bonds offered extremely low borrowing costs, often averaging around 0.5% or less. This was their borrowing side of the carry.
• Higher Yielding Investments: The Japanese trading houses, known for their stable cash flows and diversified global businesses, often pay attractive dividends. At the time of Buffett's initial investments, the blended dividend yield from these companies was reportedly around 5% or even higher, with total shareholder yields (including buybacks) sometimes reaching 7-8%. This was their investing side, akin to a higher-yielding asset.
• The Spread: By borrowing yen at a very low rate and investing that capital into Japanese companies that yielded significantly higher dividends, Buffett essentially created a positive carry. For example, if they borrowed at 0.5% and the stocks paid 5% in dividends, that's a 4.5% annual spread on the initial investment, before considering any capital appreciation of the stocks themselves.

Buffett's genius wasn't just in spotting undervalued companies, but also in utilizing the unique interest rate dynamics of Japan to fund his purchases very cheaply, thereby enhancing his potential returns and reducing his effective cost of capital.

This equity-based carry-like strategy highlights how the core principle of borrowing cheap and investing for higher returns can be applied beyond just pure currency positions. It also significantly mitigated currency risk, as the debt and the equity investments were both yen-denominated.

The Appeal of the Carry Trade

• Interest Rate Differentials: The primary driver is the ability to capitalize on significant differences in interest rates between countries.
• Leverage: Traders often use leverage, meaning they can control a large position with a relatively small amount of capital, amplifying potential returns (and risks).
• Positive Market Sentiment: Carry trades tend to perform well during periods of low market volatility and strong risk appetite, as investors are more comfortable taking on perceived risk.

The Risks: Where Things Can Go Wrong

While the carry trade can be lucrative, it's far from a guaranteed win. Here are the major risks:

1. Exchange Rate Fluctuations (The Big One): This is the Achilles' heel of the carry trade. If the investment currency (USD) depreciates significantly against the funding currency (JPY), it can wipe out, or even exceed, the interest rate differential profit.
   • Scenario: Imagine the USD weakens sharply against the JPY. When you convert your USD back to JPY to repay your loan, you might find that your USD is worth less JPY than what you initially borrowed, leading to a loss.
2. Interest Rate Changes: If the interest rate in the funding currency rises, or the interest rate in the investment currency falls, the profitability of the carry trade diminishes. Central bank policy changes are a constant watch-out.
3. Liquidity Risk: In times of market stress, it might become difficult to exit a carry trade position without incurring significant losses, especially for large positions.
4. Risk-Off Sentiment: During periods of global uncertainty or risk aversion, investors tend to pull money out of higher-yielding, perceived riskier assets and move it into safer havens, often leading to unwinding of carry trades and sharp currency movements. The JPY, ironically, often acts as a safe-haven currency during such times, meaning it strengthens, which is bad for a JPY-funded currency carry trade.

Conclusion

The carry trade is a sophisticated strategy often employed by institutional investors, hedge funds, and experienced retail traders. It requires:

• A deep understanding of macroeconomic factors and central bank policies.
• Vigilant monitoring of currency markets.
• Robust risk management strategies.
• The ability to tolerate significant volatility and potential losses.