Understanding the Carry Trade.

[MrNick]

I'm back with another question!

I'm researching the dollar carry trade and I'm curious about something. I've heard talk of the carry trade "blowing up", I assume that means people quickly move out of the dollar for carry trades? And if that's true wouldn't that cause the dollar to weaken as their is less demand for it. I was reading an article that made it seem if this happened the dollar would rally in the short term throwing off the markets and possibly causing a crash. But my understanding from a Bloomberg article a few month's ago saying the dollar was overvalued and the carry trade was propping it up.

 

[gonegolfin]

I'm back with another question!

I'm researching the dollar carry trade and I'm curious about something. I've heard talk of the carry trade "blowing up", I assume that means people quickly move out of the dollar for carry trades? And if that's true wouldn't that cause the dollar to weaken as their is less demand for it. I was reading an article that made it seem if this happened the dollar would rally in the short term throwing off the markets and possibly causing a crash. But my understanding from a Bloomberg article a few month's ago saying the dollar was overvalued and the carry trade was propping it up.

No. An unwinding of the US Dollar carry trade would result in more demand for the US Dollar as US Dollar loans would need to be repaid.

US Dollars are being borrowed at near zero interest (by banks, hedge funds, etc.) and invested in all manner of investments (driving up the value of these assets). This includes domestic equities and bonds, commodities (including oil, gold, silver), various foreign equity and debt investments, etc.

When the US Dollar is sold for foreign currency and that foreign currency in invested in higher yielding foreign assets (bonds, equities, etc.), this puts pressure on the US Dollar and the foreign currency rises in value. Investors are willing to engage in this "carry trade" as long as the US Dollar remains under pressure and there is a beneficial yield spread. This is because the loan (principal + interest at practically zero) will be paid back in cheaper US Dollars (providing additional capital gain) and the yield spread will be pocketed. This works as long as the US Dollar does not strengthen. But when it does, a wave of redemptions will ensue and the markets will sell-off violently (unwinding of the carry trade). Here, the loans must be repaid in US Dollars, causing demand for the US Dollar to rise.

Brian

 

[MrNick]

Thanks.

One more question. Is the unwinding of a carry trade a short covering?

I just found an interesting article about carry trades.

http://www.scribd.com/doc/24020426/The-Carry-Trade

 

[cbc58]

can you please give us an exact date and time when this will happen?

or, in your best guess, when it might start in earnest??