Friday, April 11, 2008

Tempted by the carry trade

The carry trade is essentially the act of borrowing in one currency at a low interest rate and investing in a second currency at higher interest rate. The investor attempts to profit from the spread between the two interest rates while taking on the risk of adverse foreign exchange rate movements. Over the last decade or so, carry trade investors who borrowed in Japanese Yen and invested in Australian or New Zealand dollars would have done very well, benefiting from both the interest rate spread and favourable exchange rate movements.

With HK$ deposit rates running at less than 1% and New Zealand deposit rates currently standing at around 8.2% (without shopping around for the best deal), I am very tempted to convert some of my HK$ bank deposits into New Zealand dollars. The theory is that with an interest rate differential of over 7%, I would have to experience annual adverse currency movements of 7% pa to be worse off than leaving my money in HK$. (Yes, I know the maths is a bit more complex than that.) There are similar deals involving a smaller spread with the AU$. Yes, I am tempted.

If I wanted to be more aggressive, I could take out a loan in Yen and invest the loan proceeds in NZ$, effectively leveraging my exposure to both the interest rate spread and the foreign exchange risk. Yes, I am tempted with this as well.

With the HK$ pegged to the US$, a bet on the carry trade is effectively a bet that the US$/HK$ peg will remain in place and that the US$ will not appreciate (or will do so at a rate less than the interest rate spread).

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