You must have heard the word called ‘Carry Trade’ thrown around after a massive fall in the markets this Monday. What does it mean?
Different economies have different interest rates. In the table below you can see the columns with the heads ‘US’ and ‘JP’. US corresponds to USA and JP corresponds to Japan.
You must have observed that irrespective of the duration, interest rates in JP are significantly lower than in the US. A trader can, hypothetically, borrow money for 5 years near a 0.4% interest rate. She can then invest that money in the US for 3.84%. In this case, the investor will make (3.84-0.4) = 3.44% returns.
This trade will stop working if JP increases its interest rates or the US decreases its interest rates. In both cases, the difference between the two rates will decrease and the expected returns for the investor will go down.
In reality, traders take leverage. In the simplest of terms, leverage amplifies risks as well as returns of an investment. So even a 0.25% movement in interest rates against your expectations can subject you to large losses. And that is exactly what happened. Bank of Japan hiked its interest rates. Now for context, for 3 decades, the interest rates in Japan have remained close to zero. It is one of the best countries in the world to perform a carry trade.
But if the interest rates rise, or if the Bank of Japan signals towards potential rate hikes, it scares the investors. In anticipation of further risks to carry trades, investors start to close their positions by selling their investments around the world and paying Japan back. This was one of the reasons behind a mass market sell of on Monday.
For long-term investors, it changes nothing. India is not overly exposed to the carry trade risk. I am not selling a single rupee of my investment in this market negativity!