How investors make money with carry trades, how central banks encourage such trades, and what are the dangers to financial markets and the economy when carry trades get too big.
What Is a Carry Trade?
Carry trades are investments in which the investor collects an income stream “as long as nothing happens,” as Tim Lee, Jaime Lee and Kevin Coldiron describe in their book The Rise of Carry. By nothing, the authors mean there is price stability in the underlying asset on which the carry trade is based. These underlying assets could be a pair of currencies, the stock market, or some volatility measure such as the VIX.
Carry Trades Use Leverage
All carry trades involve leverage in order to magnify the returns. For example, an investor could borrow money in a currency from a country in which interest rates are low and invest the money in bonds denominated in a different currency where interest rates are higher. As long as the currency where the money is invested doesn’t weaken relative to the currency in which the money was borrowed then the carry trader earns a profit. That’s because the carry trader collects more than enough interest income to offset the interest paid.
Another example of a carry trade is writing or selling put options on the stock market. The carry trader receives the premium income and will earn a profit as long as the stock market doesn’t fall below the strike price of the put option. The strike price is the price or level of the stock market that the option contract is based in which the option seller must begin compensating the option buyer.
Fleeting Liquidity and Large Losses
Carry trades earn a steady stream of income that can be disrupted by significant losses that wipe out the income earned. Those losses often force carry traders to sell assets to meet margin calls or to unwind the carry trade. Margin calls are a summons from an investor’s broker or lender to raise cash to meet contractual obligations or to offset losses.
Forced selling of assets can push down prices even more as liquidity dries up. As asset is liquid if it can easily be sold in large amounts without impacting the price. A fluctuating level of liquidity is another characteristic of carry trades. During a carry boom when asset prices are rising it is easy to borrow money and establish a carry trade. During a carry crash when asset prices are falling and lenders are less willing to lend, liquidity evaporates and prices tumble.
Carry traders crave stability in asset prices because that allows them to collect an income stream without having to suffer losses. Carry traders are short volatility, which means they can be harmed by volatile price moves in the financial markets.
One reason investors are attracted to carry trades is periods of market calm where nothing happens and carry trades earn steady profits can last for years.
David Lucca, Daniel Roberts, and Peter Van Tassel evaluated the pricing and return patterns of the VIX volatility measure and determined that “on average, extremely low volatility today predicts low volatility in the future, not higher…We find no evidence that being in a low volatility environment raises the probability of jumping to a high volatility state.”
A jump in volatility and a fall in asset prices that disrupt carry trades always come as a surprise. Carry trades are seductive because the good times always seem like they will continue indefinitely.
Central Banks Encourage Carry Trades
Central banks contribute to a feeling of stability because they have shown a willingness to act to keep interest rates low and to stem market losses by cutting short-term interest rates or expanding asset purchase plans. In other words, central banks take actions that help truncate the losses of carry traders, which further encourages more carry trades.
The Good and Bad of Carry Trades
Of course, carry trades wouldn’t exist if there were not also investors who seek protection against market losses or other bad outcomes. Those investors are willing to pay a premium to carry traders for that protection.
Carry trades are not bad. They are an important component of the financial system that matches hedgers with speculators.
Where carry trades get worrisome is when they get so big that a carry crash causes enormous losses that negatively impact the real economy. The significant wealth hit incurred by households and businesses makes them less willing to spend and invest. In addition, the economy slows because all the money borrowed to fund the carry trade needs to be paid back, also contributing to a slowing economy.
Topics covered in this episode on carry trades include:
- What are the attributes and examples of carry trades.
- Why do carry trades exist even though investors can suffer massive losses.
- What was Volmageddeon and Francogeddan.
- How central banks are the largest carry traders and their actions encourage even more carry trades.
- Why carry trades are deflationary and lead to systemic risk.
- What should individual investors do about carry trades and how to take advantage of carry crashes.
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Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I’m your host David Stein. Today is episode 283, it’s titled “Why You Should Care About Carry.”
The Rise of Carry
I recently finished a book whose authors had the same editor at McGraw Hill that I had for my book. So my editor sent it to me, I read it. Very intriguing. It’s titled The Rise of Carry: The Dangerous Consequences of Volatility Suppression and the New Financial Order of Decaying Growth and Recurring Crisis. It’s by Tim Lee who runs an economics consultancy, Jamie Lee who works for investment manager Jeremy Grantham, and Kevin Coldiron who’s a former hedge fund manager who teaches a financial engineering class at UC Berkeley.
Here’s their definition of carry: “Carry trades make money when nothing happens. The carry trader receives a stream of income or profits but is exposed to the risk of a sudden loss when a particular event occurs or the underlying asset value changes significantly.” The carry is really that income stream or the profits that the trader earns over the life of the transaction.
Carry is an example of a factor, a broad persistent driver of return. It’s a factor because the investor is receiving compensation, the income stream, for bearing certain financial risks. In this case, the risk of incurring large losses when a specific financial event occurs. In other words, it’s compensation for suffering through bad times.
Now it’s somewhat similar to an insurance company that receives premium income and then pays out if certain events occur, such as a home fire. There are 4 characteristics of carry that distinguish them from traditional insurance. Leverage, a saw-tooth return pattern, fluctuating liquidity, and short exposure to volatility. We’ll go into detail on each of those because they’ll help us understand what carry is, how investors can make money from carry, and what some of the risks and consequences are.
The biggest difference that sets apart carry from writing an insurance policy or even just lending money in the debt markets is leverage. Carry traders use borrowed funds or they invest in some type of financial contract or security where the potential loss is much greater than the amount of capital invested.
So the losses are magnified. That means the investor is very sensitive to those losses, they can be wiped out. The leverage allows the income stream to be magnified, it increases the income stream. But the potential losses are greater.
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