A closer look at the carry trade

Perpetual motion machines are justifiably objects of derision. They
violate the principles of thermodynamics and, like so many politicians, promise something for nothing. The currency carry trade, which involves borrowing a low-yielding currency, selling it, and then lending a high-yielding currency, should fall into this free-lunch category. The second currency’s higher interest rate both props up that currency and signals that the currency is at risk of a substantial decline.

Thus, when thetrade is unwound by selling the high-yield currency, it will command fewer units of the lowyield currency borrowed originally. However, this is not what was hinted at by the long-term simulated performance tables of the ABN-Amro currency trading style indices shown last month (“Currency traders should be humbler,” Currency Trader, May 2007). The carry trade index outperforms the other three — fundamental valuation, volatility response, and trend-following — by a wide margin. Let’s take a look at some elements of the carry trade in greater detail and the yen carry trade in particular.