Profiting From The Carry Trade

By Aaron Levitt | December 04, 2009 AAA

With the Federal Reserve keeping interest rates at a paltry 0.25% and the Bank of Japan hovering around 0.1%, other nations have been slowly ratcheting up their interest rates in response to their economies improving at a faster speed. Australia now sits at 3.75%, Norway at 1.50% and BRIC superstar Brazil at 8.75%. As retail investors have been looking to add sophistication to their portfolios beyond just stocks and bonds, these interest rate spreads allow investors to take advantage of a technique used by many hedge funds and institutional investors.

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Currency Arbitrage and the Carry Trade
At its core, employing a carry trade strategy is actually quite simple. An investor borrows money in a low interest rate currency, such as the dollar, yen or British pound (0.5%) and then invests the proceeds into higher yielding notes. While profit can be made if the currencies experience big moves, the real idea is to capture the spread between the two.

Using a stable currency, such as the greenback which has held the 0.25% rate steady since December 2008, forms a great base for the trade. Low volatility and reliance on futures contracts combined with this stability allows for the use of leverage. Adding leverage allows better returns than the average 2-4% interest-rate spreads between developed economies. While currency arbitrage was once the realm of large institutional investors and pension funds, the exchange traded product boom has brought the strategy to the average Joe investor's portfolio. (For more, see Currency Carry Trades Deliver.)

Bringing the Carry Trade Home
Allocating a small portion of a long-term portfolio to the carry trade may make sense as it is an uncorrelated asset class and can provide diversification benefits. Using exchange-traded funds makes this simple and quite affordable. There are two funds that exploit currency arbitrage.

The PowerShares DB G10 Currency Harvest (NYSE:DBV) uses leverage in its transactions to provide enhanced returns while shorting three low interest rate currencies and going long three higher rate notes. Additional return comes from a portfolio of T-bills used as collateral for the futures contracts. The fund can hold contacts in any of following ten currencies including the greenback, euro, yen, the Australian, Canadian and New Zealand dollars, the Norwegian krone, the Swedish krona, pounds and the Swiss franc. The fund is currently long the krone, the Aussie and the Kiwi. The ETF has performed admirably, gaining 20.4% in 2009 and 18.7% over the past 52 weeks.

Structured as an exchange-traded note, the iPath Optimized Currency Carry (NYSE:ICI) also tracks a long/short basket of G10 currencies. As an ETN, the iPath fund will have reduced tracking errors, but on the downside, it will expose investors to the credit risk of the issuing firm. Barclays (NYSE:BCS), the issuer has an AA- rating. The fund also does not employ leverage, reducing the potential returns. In addition the ETN is also long five currencies and short the remaining five. ICI has gained 4.9% for 2009 and 3.1% over the previous 52 weeks. (For related reading, check out Turn To The Carry - A Different Flavor Of The Setup.)

While the preceding funds make the carry trade easy, more active investors could potentially borrow dollars and invest them in any of the various single currency funds. ETFs exist for the euro (NYSE:FXE), yen (NYSE:FXY) and aussie (NYSE:FXA).

The Bottom Line
With some nations' economies moving at slower rates than others, interest rates continue to be low. Retail investors now have the ability to participate in transactions normally reserved for larger institutional clients. Using exchange-traded funds, currency arbitrage and carry trade strategies can be implemented for any portfolio size. (For more on this topic, check out Profiting From Carry Trade Candidates and The Credit Crisis And The Carry Trade.)

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