Carry Trade

Amid nerves over subprime mortgage derivatives, another threat to the financial system has been overlooked: the carry trade. This is where investors borrow in currencies with low interest rates – mostly the yen and the Swiss franc – and invest the money, often supplemented with leverage, in assets priced in higher-yielding currencies.

A major symptom of the global credit bubble, the carry trade has spilled over into debt, equities and real estate. The New Zealand dollar (a popular carry-trade destination) is now about 20%-25% overvalued against the US dollar, while the yen is about 30% under-valued. As exchange rates ultimately converge “sharply” with fair values, losses for leveraged speculators on their currency positions could reach about $550bn, as the trade is worth around $1.5trn globally, reckoned. Other markets would be affected by the fallout.

So lets see how it works out