The Carry Trade
Central banking and interest rate policies are incredibly important to all forex traders. Interest rates directly affect global money flow, and money naturally finds its way to the highest interest rate economies. How can you trade like a hedge fund manager?
Borrow cheap money to trade with!
Take out a loan from the Bank of Japan. It only charges you a half of a percent (0.5 percent). That’s a cheap loan, eh? Now use that money to trade with. You’ll still have to pay the loan back plus interest, but it’s essentially free money. See Figure 4.1
What do hedge fund managers do? Let’s say the manager has a billion USD of client money. The manager can borrow $25,000,000,000 USD or more worth of Japanese yen from the Bank of Japan depending on leverage (example assumes just 25:1).
This loan costs the hedge fund 0.05 percent in interest payments. Now the manager converts the yen to NZD and puts it into the Bank of New Zealand. As discussed, the investment earns 8.25 percent annually. The interest rate differential, the difference between the interest earned and interest paid is 7.75 percent.
Interest ®ates, Exchange ®ates, and Carry Trade Attractiveness
Bank for International Settlements (www.bis.org
That is great ROI! This trade, ...