Friday, September 18, 2009

The U.S. Dollar and the Carry Trade Made Simple

Let's say two people have bank deposits: one at United States Bank and the other at Euro Bank. United States Bank is offering a one-year certificate of deposit for .35%. Euro Bank is offering .36% at its UK branch and .68% at its German branch. Japan Bank is advertising only .16% for its 12-month deposits. Australia Bank, however, is offering one-year certificates of deposit for 3.69%, and Brazil Bank is offering a whopping 10.00% for one-year deposits.

Which banks will see outflows? Which will experience inflows? (Hint: See the currency charts above).

Under what conditions would we choose to place our money in Japan Bank rather than United States Bank?

Currency traders are not so unlike commercial bank customers: they vote with their feet when it comes to perceived rewards and risks. They will pursue higher returns when those returns are perceived to justify the risks. That is why the carry trade is a risk-seeking trade, and it is why the U.S. dollar has fast emerged as a major funding currency for that trade.