What is a carry trade?

 Hi All,

Someone asked me this at a recent dinner party, probably to catch me out...

A carry trade is borrowing in one currency and investing in another. The profit to be made is the difference between interest rates or the potential gain. 

For banks, the classical example is Japan, who was the king of carry trades woth $1 trillion, until the 2008 crash, when the trades began to unwind due to the lowering of interest rates in Europe, America and the UK. Banks would borrow in Japanese Yen, which came with a low interest rate and then lend this money in currencies that attracted a higher interest rate (such as the UK or another OECD nation). So the profit would be classical banking, or   the difference between borrowing at 1% and lending at 6 or 7%. 

For individuals a carry trade is using the entire limit of a 0% credit card before the interest is applied and investing it in either a saving account (little to no risk, but low rate) or if one wishes a higher, but riskier, return the stock or derivatives market.

A subset of the carry trade exists in the EU, which while it has the same currency has different yields for its bonds. In 2011 the ECB began one of its many LTRO (Long Term Refinancing Operations), which allowed Europe's banks to collectively borrow trillions, the collateral for these loans was of course  European government debt, but the ECB was not quite the ultra conservative Bundesbank as it accepted and did not discount or discriminate between member states .  The banks were able to use the bonds of Italy, Greece, Spain, Portugal, Ireland etc to get 100% of their face value,  which then they used to buy... more bonds of the same. why? Aside from the national pressure the  banking sectors in each country probably came under to buy 'our' debt, the capitalist insentive was the carry trade : the  interest rate spread (profit)  between the cost of borrowing from the ECB at 1%  (the carry) to these  bonds (Italy 5%, Greece 20%).