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Studying for a test? Prepare with these 8 lessons on Money, banking and central banks.
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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.