Tuesday, July 12, 2011

The "Carry-Trade" explained---Short lesson on how to make money in the Foreign Exchange Market. Don't try this at home!

Here is a quick lesson on the "Carry Trade". In its most simplest terms, this is borrowing money in one currency (i.e. US dollars) at a low interest rate and investing it in another country that currently offers savers/investors a high interest rate (i.e. Brazil--currency called the "Real").  I will use Brazil because it does in fact offer relatively high interests rates to savers/investors.  Of course, we will have to exchange our dollars for the foreign country currency in order to do this so we have to take into consideration the prevailing exchange rate for the two currencies.

There are 2 ways for the holders of dollars to make money--(1) the difference on the spread between the interest rate at which you borrowed the money and interest rate you received from the investment you put the money in (assume the exchange rate stays constant), and (2) IF the foreign currency you currently have the money invested in APPRECIATES in value during the time you hold the investment. 

Look at the first scenario first.  Right now it is "cheap" to borrow money in the US and the interest rates that Brazilian banks offer savers in relatively high.  I am going to use ballpark numbers because, well frankly, the math is easier.  Assume I can borrow money in the US at a 5% interest rate for one year.  If I borrow $1,000 I will have to pay the bank back $1,000 plus $50 after 1 year ($1,000 times 5% = $50)) for a total of $1,050.  I am going to invest this $1,000 in a bank in Brazil because it offers 10% interest rate to savers. 

First, I have to exchange my US Dollars for Brazilian Reals. Assume today the exchange rate is $1.00  = 1.76 Reals. With my $1.000 US dollars I can "purchase" 1,760 Reals. I put those Reals in the bank and start earning my 10% interest.

After one year I will have 1,936 Reals in my Brazilian bank (1,760 + 176 (10% of 1,760). I must withdraw this money so I can pay back the US bank for the money I originally borrowed.  ASSUME the exchange rate did not change at all (it did, but more on that in a minute).  To go from Reals to Dollars, I have to calculate the reciprocal of the exchange rate. The reciprocal of $1.00 = 1.76 Reals is 1.00 Real = $.5681 cents.   If we multiply 1,936 Reals by $.5681 we get $1,100 (rounded). We now take $1,050 of this and repay the bank what we owe them.  We have $50 left over! In real life, we would have to pay a fee for the currency transaction when we bought and sold, so we would have to subtract that from our $50.  BUT, you can see how you can make money by borrowing in one currency and saving/investing in another.

Now, what if the exchange rate changed while you had your money in the Brazilian bank? The exchange rate I used above for the Real was the exchange rate from July 12, 2010, one year ago.  TODAY the exchange rate is $1.00 = 1.58 Reals.  Now $1.00 US buys FEWER Brazilian Reals which means the inverse is true---The Brazilian Real buys MORE US Dollars than before (1.00 Real =$.6329 cents). Let's use this to see how our investment fared.

If today we exchange our 1,936 Reals for dollars we get 1,936 times $.6229 cents = $1,225 (rounded). NOW, when we pay back the loan plus interest of $1050 we will have $75 left over (minus fees).  We have an additional $25 just because to the change in the exchange rate between the Dollar and the Real. Easy money, right???

The trick to this is to (1) find a country where the interests are higher relative to the US, (2) it is stable enough to invest in, and (3) the currency appreciates while it is earning interest.  Of these number 3 is the most risky and difficult to predict. If the Real had DEPRECIATED in this time period, you could have lost not only the interest you earned BUT some of the principle as well.

Even if the exchange rates stay relatively constant, you can see how you can make money in the "carry-trade". The appreciation of the Real was a bonus.  However, this strategy is risky and is not recommended by professional financial advisers unless your investment portfolio can withstand the risk.
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