Carry trading and markets at a glance

All you smart economists out there probably already know about carry trading; what it is, what it means, and what consequently I am going to talk about in this entry. Basically carry trading means to borrow short and invest long; or put in another way ...

"(...) carry trading is done when the investor feels that the two securities are mispriced with respect to each other, and that the mispricing will correct itself such that the gain on one side of the trade will more than cancel out the loss on the other side of the trade."

So basically, think of it as arbitrage. In fact it is abitrage.

Moving away from the realms of theory we see that carry trading and its implications are very much on the agenda at the moment. One of the most notable example comes from Japan ... 

"During the past decade, the yen-carry trade has become a staple for many punters. A popular form of the strategy exploits the gap between U.S. and Japanese yields. Anyone borrowing for next to nothing in yen and parking the funds in U.S. Treasuries received a twofold payoff: the 3-plus percentage-point yield difference and the dollar's rise versus the yen. The latter dynamic boosts profits by the time they're converted back to yen.

Yet as the BOJ raises rates and more investors buy into Japan's revival, the yen is sure to rise, much to the chagrin of carry-trade aficionados. Realization the trade is moving against investors may send shockwaves through global markets."

The quotation above shows the dynamics in a nutshell and with all the major central banks raising interest rates we are
bound to see some wobbly markets around the globe as emerging economies' currencies take the fall (Brad Setser).

(from the Economist - walled for non-subscribers) 

"(...) the BoJ has been responsible, along with America's Federal Reserve and the European Central Bank, for an exceptionally long period of unusually accommodative monetary policy. The other two have already begun to tighten. If policy becomes still tighter all round, it is hard to see global bond yields staying at their recent low levels (see chart). And third, investors might ask whether it is worth hunting out high-yielding assets in emerging markets and leveraged credit markets, if they can get attractive returns in safer places."

The question obviosuly is how severe and widespread remnification the necessary unwinding of this is going to have. Apparently, it all depends on what assets all this arbitrage hunt has been put in. The more riskier and volatile these investments are the deeper the fall. Especially when (as) Japanese yields begin to rise and the yen appreciates we may very well see a rough unwinding. Consequently, my sources on this entry particularly seem to call for attention on the yen/carry trade.

(Brad Setser)

"The yen carry trade, though, is an altogether different beast. As William Pesek has noted, no one has a good sense of the scale of the yen/dollar carry trade.  But no doubt this trade is one vector - along with Japanese real money investors looking for yield -- that has helped to bring Japan's current account surplus to the US after the MoF and BoJ stopped intervening in the spring of 2004. And if investors lost interest in that carry trade in a big way, watch out."

Regarding emerging economies in general who have also been subject to steady inflows of carry-trade capital Brad Setser assures us that much of these inflows have been stacked in the reserves and as such do not represent financial volatile capatial. But what about when Icelandic tycoons travel to Denmark buying up assets on the back of a booming economy owing much of its vigour to carry-trade. Is this not spreading like rings in the water or am I getting carried away?