Let's say that the economy
of country A is stagnating. It may be facing a
deflationary crisis. So central bank tries
to print as much money and lower interest rates
as much as possible. And an investor can
go into country A and borrow in A's currency
at a 1% interest rate. Let's also say that in
the rest of the world, and in particular, in
country B, one can actually make relatively, or what you
perceive as safe investments at a higher interest rate
in country B's currency. So let's say that you
can get a 5% return. So you could imagine some
opportunistic investors might say, wow, I could borrow
in country A's currency. And so let's say they go into
country A. They borrow at 1%. In particular, they borrow 100--
and I won't call them dollars or yens, I'll call them--
or anything, or euros, or anything else- I'll call
them 100 A's, where the name of A's currency is an A. So they
borrow 100 A's, and let's say the conversion rate
is-- at right now, at this point in time,
one A is equal to two B's. So they go into
currency markets, and then they exchange it. For every one A,
they get two B's. So they exchange it for 200 B's. And then they go and invest it. They are investing in B's. So this is-- they're borrowing
in A's and they're investing in B's. And so what would happen? Well, they're going to get
5% on their money in B's. So 5% of 200. They're going to get 10 B's--
let's say that's per year-- so they're going to get 10
B's in interest every year. And then they can convert that. They can convert
those 10 B's, if we assume the exchange
rate holds constant. And that is a big assumption. They can convert
that to five A's based on the same exchange rate. And so that will be
five A's, but they only have to pay one A in interest. So let me divert some over here. So they only have to
pay one A in interest. And so they're just going
to get four A's per year. If we assume constant
exchange rate, they're going to get four A's
a year for free-- assuming that they could
continue to do this. And then they could take those
four A's and convert them to B's, or whatever
other currency they want. So they could
just-- you could say they're getting four
A's for free every year, or they're getting eight
B's per year, every year. And this little process,
this little trade, this little perceived
arbitrage that's going on right over here, this
is called the carry trade. And you might think about well,
where would this break down? Well, the main area where
this would break down is while you are borrowing
in A and then investing in B, if A's
currency appreciates, especially relative
to B's currency. Because then what happens, even
though you have this interest rate discrepancy, and
even though you feel like you're getting a lot of 10 B's. Those 10 B's are going to
give you fewer and fewer A's if A keeps appreciating. Or another way to
think about it is, you're going to, in terms
of B's, even though you think you only owe 1% interest,
A is also going to appreciate. So in terms of B's, you're
going to owe more and more B's every year if A appreciates. Now what's worked out
in the carry trade, or at least the most
famous of the carry trades, where in starting
in the mid-90's, people started borrowing in Japan
because they had low interest, and then investing other
places like the US, and especially other
places, like Iceland, is that the more people do
this-- so you can imagine, if a lot of people
keep doing this and it becomes kind of a big
herd affect, what happens? You have a bunch of
people borrowing in A and then converting it to B. So they're taking this
currency and converting it to the magenta currency. And if that happens,
then you actually have the opposite effect. Then you get a benefit on top
of the interest rate discrepancy because that means the demand
for B's currency goes up, and demand for A's goes down. And this is essentially
what happened, relative to Japan-- and a
lot of the rest of the world when Japan had it's
lower interest rates, all the way until really about 2008.