Carry trade basics

let's say that the economy of country a is stagnating it's 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 na s currency at a 1% interest rate let's also say that in the rest of the world and in particular in country B you one can actually make relatively or what you perceive is safe investments at a higher interest rate in company in in country B's currency and so let's say that you can get a 5% return so you can 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 they borrow 100 and I won't call them dollars or yen's I'll call them or anything or euros or anything else I'll call them 100 s where the the name of a currency is an a so they borrow a hundred a's and let's say the the the conversion rate is at right now at this point in time one a is equal to 2 b's so they go into currency markets and then they exchange it for everyone a they get 2 b's so they get exchange it for 200 B's they exchange it for 200 B's and then they go and invest it they are investing in B's so this is their borrowing and a's their borrowing and a's and they are investing in B's and so what would happen well they're going to get 5% on their money and 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 5 a's based on the same exchange rate and so that will be 5 a's 5 days but they only have to pay one a and 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 they're 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 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 this is called the carry trade and you might think about well where where would this break down well the main area where this would break down is while you are borrowing an A and then investing in B if a is currency appreciates if a is currency appreciates or especially relative to B is 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 bees even though you think you only owe 1% interest a is also going to appreciate so in terms of bees you're going to owe more and more bees every year if a appreciates now what's worked out in the carry trade or at least the most famous of the carry trades we're in starting in the mid 90s 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 effect what happens you have a bunch of people borrowing an 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 its lowest lower interest rates all the way until really about 2008