The Carry Trade is Alive and Well with Currency ETFs

While the Global Financial Crisis of 2008 has witnessed many casualties in the banking centers of the world, the ability of many institutions to trade with each other has eroded, if not for insolvency, for tighter credit controls, policy, and procedure within the financial markets of the world.

The carry trade traditionally has allowed investors to forgo earning interest in one currency for that of an interest bearing deposit in another currency. The motivation to enter into such a transaction stems from the view that the interest earned in another currency would outperform that earned in the domestic currency. Of course the investment does not accrue profits until the position is reversed and the domestic currency is once again held. This feature of the investment adds another dimension in that a capital risk also exists in addition to the interest earned or forgone. Economic, fundamental or technical properties of various nations can provide the basis for currency investment and divestment in a multitude of currencies in order to exploit price differentials, but trading partnerships between the countries of the world necessarily offer a connection between certain currencies and others. These relationships will determine the structure of an investment and the elements it is comprised of. Currency ETF options offer the most flexible and leveraged opportunities to traders wishing to implement carry strategy or synthetic arbitrage strategy between trading partner nations.

If for example Australian interest rates offered an investor 4% returns while holding $A , compared to a 1% return in say the United States while holding $US, selling $US and buying $A would allow investors to execute a carry trade in order to trade the interest rate differential. Of course the capital risk upon conversion at the conclusion of the trade has the potential to offset any profit already made, and so the device of the currency ETF option is the perfect tool to quantify risk and yet not risk a large capital loss on strategies playing the interest rate differential.

Purchasing outright currency ETFs will invariably pay lower than retail interest in that nation’s currency, but the interest will reflect domestic conditions and so can accurately be used to execute the carry trade.  Of course the actual fruits of the carry trade – the interest accruing over time need not be sought; a capital gain from the investment will accrue due to market forces if indeed value is perceived to exist in a particular investment. While a multitude of variables come into play to make this determination, it is the preempting of value in an investment that high lights the versatility that currency ETF options offer investors who seek to trade currency differentials. At a fraction of the cost of exchanging hard currency, these derivatives are second to none in terms of currency market leverage.

 

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