Understanding carry trade

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MARKET INSIGHTS

Understanding Carry Trade
MARCH 2007

Emergence of the international carry trade
Historically it was typically commercial banks that exploited the carry trade by borrowing cheaper short-term funds in their domestic credit markets (for example in the short-term money market) and lending at longer maturities in the same domestic credit market (either by making loans to corporate or individual customers or by buying government or corporate bonds). It was this spread between short- and long-term funding costs that made it attractive to “create credit”. In the early part of the business-cycle expansion when short-term interest rates were usually lower than long-term rates, money and credit growth accelerated. To curtail monetary growth as inflation picked up, central banks would raise short-term rates until the yield curve was either flat or inverted. However, in recent years this phenomenon has spread from domestically oriented banks to a much wider range of internationally oriented financial institutions. Two factors have helped to create the phenomenon of the international or cross-currency carry trade. First, the enhanced efficiency of the credit markets, driven partly by the development of information systems and risk management technology, especially computer-driven trading systems featuring automated stop-loss options and a variety of protective derivative contracts, plus the diffusion of these trading techniques, has greatly increased the ability of institutional and even medium or small investors to participate in these transactions. Second, the “Great Moderation” * caused by the improvement in macroeconomic management techniques over the past decade and a half has played a significant role in reducing volatility in a range of markets, encouraging investors to take risks across asset classes that they previously would have been reluctant to contemplate.

Recently, we witnessed a sell-off in risky assets and the unwinding of associated yen

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