By Alex Mui '17

Foreign-exchange (forex) has historically been a very lucrative trading option for those with the capital to participate. However, due to the chaotic atmosphere surrounding many currencies – particularly the Euro – traders have been forced outside of their traditional comfort zones within the forex market.

One of the bread and butter strategies for a forex trader is known as “carry” trading. This involves borrowing a weak currency in a country offering low interest rates and subsequently investing in a country with significantly higher rates. Doing so allows a firm to generate higher profits by purchasing bonds with a yield far greater than the interest rates available for the original currency. Common trades in the past usually involved borrowing the weak yen at near zero interest rates, and subsequently purchasing bonds or investing in currencies such as the US dollar. Low Japanese interest rates have depreciated the yen against other currencies, and using it in a carry trade boosts the bond market in the United States and strengthens the dollar. After the investment has been made, the carry trade will generate profits from three different sources: the appreciation of the dollar against the yen, rising bond prices and the yield of whatever bonds have been purchased being higher than the interest rates of the original currency (the yen, in this case).

The already weak euro is expected to continue its downward trend as the strong dollar and European Central Bank’s (ECB) bond buyback program show no signs of relenting. This rapidly depreciating Euro is too appealing for carry traders not to explore the possibilities of using the newly weak euro to fund transactions in emerging markets such as India and Indonesia. These markets tend to offer higher yields on their bonds, but are also relatively stable nations, with new leadership promising strong economic growth.

The implications of such strong demand for the euro are huge. The short term economic stimulus could definitely help to stabilize a tumultuous Eurozone. Moreover, the strong market reaction seems to indicate that investors believe the low interest rates within the United States will soon be no more. As transactional costs rise with those interest rates, the question arises: could the newly cheap euro become the new standard transactional currency? If it does, it will certainly be a boon to the second largest economic bloc.

Carry trading is by nature a risky proposition, as any number of events could sour a transaction, including unexpected moves by central banks or swings in the volatile foreign exchange market. Engaging in such untested strategies only amplifies that innate unpredictability. So while this new variation on carry trading is an exciting prospect, it should be approached with caution appropriate to the risks involved.

Sources:http://www.wsj.com/articles/europe-stocks-sink-to-11-year-low-against-dollar-1425977896http://www.wsj.com/articles/investors-forced-to-get-creative-for-carry-trade-1426093676http://www.wsj.com/articles/euro-steadies-german-government-bonds-fall-after-weak-u-s-data-1426237658http://www.telegraph.co.uk/finance/comment/liamhalligan/11472336/Currency-wars-threaten-Lehman-style-crisis.html