Involves borrowing in one currency where interest rates are low and then using the proceeds to invest in another currency where interest rates are high.
A kind of speculation that has become more common in recent years is known as the carry trade (see the opening case for a discussion). The carry trade involves borrowing in one currency where interest rates are low and then using the proceeds to invest in another currency where interest rates are high. For example, if the interest rate on borrowings in Japan is 1 percent, but the interest rate on deposits in American banks is 6 percent, it can make sense to borrow in Japanese yen, then convert the money into U.S. dollars and deposit it in an American bank. The trader can make a 5 percent margin by doing so, minus the transaction costs associated with changing one currency into another. The speculative element of this trade is that its success is based upon a belief that there will be no adverse movement in exchange rates (or interest rates for that matter) that will make the trade unprofitable. However, if the yen were to rapidly increase in value against the dollar, then it would take more U.S. dollars to repay the original loan, and the trade could fast become unprofitable. The dollar–yen carry trade was actually very significant during the mid-2000s, peaking at more than $1 trillion in 2007, when some 30 percent of trade on the Tokyo foreign exchange market was related to the carry trade.2 This carry trade declined in importance during 2008–2009 because interest rate differentials were falling as U.S. rates came down, making the trade less profitable.
ANOTHER PERSPECTIVE Key into Exchange Rate Language
The language used to describe exchange rates can be confusing, even though the ideas themselves are simple. Here’s why: Any given observation describes a changing relationship (the movement in the currencies) that itself describes two relationships (the exchange rates for both currencies). The important thing to remember is that an exchange rate is described in terms of other exchange rates.
The language we use to describe these moving phenomena works in a similar, dual way: The euro gains against the dollar, so the euro is strengthening, or becoming dearer, from a dollar perspective. Meanwhile, the same observation indicates its mirror image, that the dollar is weakening, becoming cheaper against the euro, from a euro perspective.
• QUICK STUDY
1. Why do international businesses need to use the foreign exchange market?
2. What are the risks associated with currency speculation?
INSURING AGAINST FOREIGN EXCHANGE RISK
LEARNING OBJECTIVE 2
Understand what is meant by spot exchange rates.
A second function of the foreign exchange market is to provide insurance against foreign exchange risk, which is the possibility that unpredicted changes in future exchange rates will have adverse consequences for the firm. When a firm insures itself against foreign exchange risk, it is engaging in hedging. To explain how the market performs this function, we must first distinguish among spot exchange rates, forward exchange rates, and currency swaps.