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Tuesday, March 25, 2008

The Carry Trade

The "carry trade" is a mechanism whereby traders exploit central banks and their subsidized negative interest rates. The carry trade involves borrowing from the central bank that offers the lowest interest rate, and then investing in tangible assets and waiting for inflation.

The most famous example is the yen-gold carry trade. While the Japanese yen had 0% interest rates, people would borrow yen and buy gold. This was a practically riskless trade. The yen-denominated price of gold was practically guaranteed to rise as the yen was inflated.

The carry trade also can be used to borrow in a currency with a low interest rate and buy bonds in a currency with a higher interest rate. The risk of this trade is that exchange rates may change unfavorably.

The carry trade can be broadly be defined to ANY situation where you borrow at a negative real interest rate and buy tangible assets. For example, the typical hedge fund borrows from the Federal Reserve and buys stocks. The spread between the Fed Funds Rate and the true inflation rate is around 10%. Using 7x leverage, this means that hedge funds can make a 70% profit just from the difference between the borrowing rate and the inflation rate.

In a free market with an international gold standard, there's NO SUCH THING as the carry trade. With an international gold standard, and free shipment of gold between countries, interest rates must have nearly the same value everywhere! Otherwise, someone could arbitrage interest rate differences by shipping gold from one location to another.

The carry trade is one of many ways that financial industry insiders exploit central bank subsidized negative real interest rates. The profitability of the carry trade is a symptom of a defective monetary system. Don't blame traders who exploit the carry trade. Blame the corrupt monetary system that rewards such behavior.

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