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Carry trade basics

The mechanics of the carry trade. Created by Sal Khan.

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  • leaf green style avatar for user PetoG
    Wouldn't the high demand for borrowing money in A increase the interests in A (and the high amount of money supplied to B decrease the interests in B)?
    (13 votes)
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    • duskpin ultimate style avatar for user tuannb1997
      I assume that when currency A is converted into currency B, the central bank of B would spend the money on buying A's government bonds, which therefore leads to lowered interest rates in A, as demonstrated in previous videos by Sal. On the other hands, currency B, after conversion would be used to invest in B's economy. Now that B's economy expands at rapid rate, the central bank would have to increase interest rates to cool down the overheating economy (if the price of money is high, people would be discouraged to borrow it, which leads to less consumption of goods and services in the market)
      (7 votes)
  • leaf red style avatar for user Hope Gold
    At almost the end of the video, Sal says the demand for currency from the country everyone's borrowing from goes down, and the demand for currency from the country everyone's investing in goes up. But if people are borrowing A's (/yen/etc.), isn't that a demand for that currency? Thanks!
    (3 votes)
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    • blobby green style avatar for user adlosh
      That's a good point your bringing up. I think when you break it down, however, there isn't real demand for currency A. All the people that are borrowing from that currency are not holding it, they are immediately converting it to the other currency. So, you have this kind of constant flow of that money, they are not really creating a "real" demand. Now, the people that are already holding that currency, say, people that live there, or they were invested there they all want out as well, and that is causing the real dumping of that currency.

      By contrast, the country that has the higher rate, there people are in to stay. So, like before but the opposite, meaning, the people that were already holding that currency and exchanged it to get currency A when they switch back now they are not creating "real" demand. But everyone else that is now coming into that market are causing more demand for that currency.
      (10 votes)
  • leaf green style avatar for user ericlrice60
    Is it worth considering whether this method of "investment" is generally harmful to the world? Is there really any actual value added to the world as a result of this method of "earning" income?
    (2 votes)
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  • male robot donald style avatar for user harry park
    If A's currency appreciate, why would that hurt the investor engaging in carry trade?
    (1 vote)
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  • winston default style avatar for user adinsx0001
    Sal seems to imply that borrowing in Yen to invest in other currencies slowed significantly in 2008. Did this happen because of a policy decision in Japan, or was it related to the fallout of Lehman and Bear Sterns?
    (1 vote)
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  • blobby green style avatar for user sudeep.dennis
    As Sal said towards the end of the video, at the time when you buy currency B, currency B appreciates when a lot of people do that. But....when you are trying to buy back A, the reverse will happen(B will depreciate) and won't it nullify this effect (of the originally appreciating B)?

    In terms of an eg, 100As -> 100 Bs(because B appreciated since everyone is buying B ) -> 5% = 5 Bs -> 2.5A (because B depreciated bcos everyone is selling B). And 2.5A is just half of 5As which we got originally.
    (1 vote)
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    • blobby green style avatar for user David Land
      What you are saying would be correct if everyone moved into B, and then out of B at the same time. In an FX trade you are always buying one currency and selling the equal amount of another - so supply increases for one at the same rate as demand increases for another. In reality this would happen incrementally as different people moved in and out of the currencies over time.

      As was said in the video, leading up to the GFC money was flowing out of Japan (forcing the yen lower) and into other countries (New Zealand was also a good example). This became a really popular trade for a lot of people using margin FX.
      What you said isn't a problem as long as there isn't a stampede of money back to Country A (or Japan as was the case). When the GFC started to bite there was a surge of money back to Japan which meant that you lost more on the change in currency rate than you made on the carry trade.

      The important thing is not to look at the potential profit from the carry trade in isolation. The potential profit or loss from capital movements due to changes in the exchange rate will be much larger than the interest rate benefit.
      (1 vote)
  • piceratops seed style avatar for user hpjm37
    Why would they get 1A deducted as interest if they are only converting B to A?
    (1 vote)
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  • blobby green style avatar for user jimdetry
    Sounds great. How does an investor get a piece of this scam?
    (0 votes)
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  • leaf green style avatar for user Antara Rao
    Basically it is a problem for UK to have its currency appreciate at tho cost of chinese loan because the currency then becomes dependent on that right, so how will buying up US assets change that?
    (0 votes)
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    • blobby green style avatar for user Arturo
      The thing is that the UK government moves those incoming cash flows from China back to US treasuries because they don't want their currency to get dependent, as you said or, in other words, to let it become more appreciated artificially, because there'll be speculative bubbles in UK and a higher prices on their export goods. The price of pounds, once rised because of a higher demand on UK treasuries (they actually have another name, but they are the same in essence), dropped again, as UK raised price for dollars when they bought US treasuries, so we're on our starting point again
      (1 vote)

Video transcript

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.