Carry Trade

Carry Trade: A series of transactions where you borrow and pay low interest in order to buy something else that pays you a higher interest. For example, if a Bank can receive a short-term loan at 4% and re-loan that money out at 6%, they can pocket the 2% difference. Because they deal in large sums, 2% translates into huge flows of profit.

The term, "carry trade," has also been used recently in relation to currency trading. It's a classic arbitrage. Here's an example or a "yen carry trade":

Let's say a trader borrows 1,000 yen from a Japanese bank, converts the funds into U.S. dollars and buys a bond for the equivalent amount. Let's assume that the bond pays 4.5% and the Japanese interest rate is set at 0%. The trader stands to make a profit of 4.5% (4.5% - 0%), as long as the exchange rate between the countries does not change. Many professional traders use this trade because the gains can become very large when leverage is taken into consideration. If the trader in our example uses a common leverage factor of 10:1, then she can stand to make a profit of 45%. [1]

The risk is that the underlying rates could change. First, in the first example of the bank, if the short term rates increase above 6% the bank will be loosing money, and will need to quickly pay off the short-term loans. This is called "unwinding" the loans. If the bank does not have funds to pay off (unwind) the short-term loans, they could bleed to death.

Recently, there has been a lot of talk about unwinding the yen carry trade. It's part of the story of recent Wall Street stock drops, and the subprime real estate market "unwinding" process.

Sources:

1. Investotopia