One working definition of a professional investor is: somebody who needs to care about “carry.” The classic carry trade is the mid-90′s best against the Yen (I’m going to borrow from this Mark Dow writeup, because I am a macro tourist—literally, my main macro trade is that I avoid traveling to Europe when the Euro is strong). The Yen bet: the BOJ intended to keep rates low; rates in the US were high. So a smart person could borrow Yen, invest in USD, and pocket the difference. A smart person with risk tolerance could do this several times over, and make a very nice return indeed.
As it turns out, one risk of carry trades in FX is that they are a pretty good deal most of the time, so lots of hedge funds get involved, so when something else blows up, they unwind their carry trades, too. So at any given time: a) the carry trade is earning a positive return from the interest rate differential, b) the trade also has a tailwind from more people making the trade (ie every new “borrow Yen / short USD” transaction, but c) at any given time, there’s a possibility of a sudden and painful reversal.
Fortunately for anyone involved in such a trade, you earn your 2 and 20 on performance at a specific time, not on the expected contours of future performance. So for someone who wants pretty good odds of a pretty good return, a carry trade is a pretty good bet. Read the rest of this entry »