Currency Carry Trade in Brazil

In the end of 2010 I wrote about the tax on capital inflows here in Brazil. Our country imposed a 2 percent entry tax (the IOF) on inflows to domestic bonds and equity markets on October 19, 2009. Moreover, I was taking a look at the stats of this blog and surged more than 50 search keywords related to "onshore offshore spreads Brazil", the so called carry trade. But, what is that? What are the advantages for the foreign investor? How they do that?

According to Investopedia, Currency Carry Trade is a strategy in which an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate. A trader using this strategy attempts to capture the difference between the rates, which can often be substantial, depending on the amount of leverage used.

For example, a trader borrows $10.000,00 US dollar from a American Bank, converts the funds into BRL (Brazilian Real) and buys a bond for the equivalent amount here in Brazil. Let's assume the brazilian bond pays 11.25% and the american interest rate is around 0.25 percent. The trader stands to make a profit of 11% (See, I'm not adding the 6% entry tax, If I did that, the trade still can make a big profit) as long as the exchange rate between the country does not change (USD/BRL). 

The big risk in a carry trade is the uncertainty of exchange rates. Using the example above, if the U.S. dollar were to fall in value relative to the Brazilian Real, then the trader would run the risk of losing money. Also, these transactions are generally done with a lot of leverage, so a small movement in exchange rates can result in huge losses unless the position is hedged appropriately. Still, this trade nowadays has been advantageous for the foreign investor that invest in dollar. Why's that? Brazilian economy growing fast, economic and political stability, government spending is almost under control comparing to developed countries are some indicators that keep the U.S. dollar in this range of 1.60 - 1.70, drecreasing the chances of drastic losses.

Another example of Carry Trade

Below is a chart illustrating a typical example where the carry trade strategy could have been best applied. The chart shows a steady increase of the GBP/JPY pair in 2005 and 2006, spawned, among other things, by carry traders going long to obtain the interest rate differential. 

A carry trader who took advantage of the interest rate differential in the GBP/JPY would have had the following profit, had he/she bought one standard lot of the GBP/JPY at about the same time last year, and decided to sell a year later. 

 

Sources: Fxwords, Investopedia, Brazilian Central Bank.

Warren Buffett's secrets revealed : Buffett & Clark

Mary Buffett, the former daughter-in-law of billionaire investor Warren Buffett, and David Clark, one of the earliest 'Buffettologists', say they revealed Mr. Buffett's investment secrets in their recently published book Warren Buffett and the Art of Stock Arbitrage.

The billionaire Omaha investor returned about 39 percent annually from 1980 and 2003, which is an 

astounding investment feat. However, these numbers look shabby compared to the 81 percent annual returns he achieved with the 59 stock arbitrage deals he did between 1980 and 2003. Clark and Mary Buffett claims this is the secret to Buffett's success.

Stock arbitrage, also known as merger arbitrage, involves buying the shares of companies that are expected to be acquired by another company.

Usually, after an acquisition is announced, the price of the stock jumps close to the acquirer's proposed purchase price. Stock arbitrage, then, is buying those shares and gaining from the eventual convergence to the exact announced purchase price.

The downside risk, of course, is if the deal doesn't go through and the prices drop all the way back to pre-merger announcement levels.For this reason, investors must be very "choosy" when doing these deals, said Mary Buffett, in a phone interview with IBTimes. Warren Buffett was certainly "choosy"; all 59 of his stock arbitrage deals went through.

Mary Buffett said the billionaire investor forgoes the greater returns of buying early in the speculative phase of the potential merger. Instead, he waits until the deal is "certain" to happen before he acts.

Buffett and Clark list the following as the characteristics of the deals that are likely to go through:

*The takeover must be friendly and no large shareholder should oppose it. 

*The acquisition should be made for strategic rather than financial reasons, i.e. a company buying another one because there is synergy rather than a private equity firm buying a company it thinks is undervalued.

*There may also be regulatory considerations. For example, if the two companies together control a large enough portion of a  certain market, regulators may oppose the deal on anti-trust basis.

Buffett and Clark insist stock arbitrage is a good strategy for retail investors. Years ago, it was impractical because of the high trading costs involved. 

Now, with the advent of electronic trading and lower commissions, it's more feasible.

Moreover, to follow the mergers market, one just needs to pay attention to general financial news.  There are also a number of websites that specifically track mergers, so keeping abreast of this market is easier now than ever, said Mary Buffett.

Also, mergers still happen in recessionary times. For example, Warren Buffett's Berkshire Hathaway (NYSE: BRK.A) bought Burlington Northern in late 2009. However, it is not possible for retail investors to achieve Buffett's 81 percent annual returns because they typically can only leverage two times 

for stock purchases.

Warren Buffett returned 81 percent annually by doing about 2.5 deals per year. Assuming each deal returned on average three percent, his leverage was at least nine times. Still, with just two times leverage, investors can make some pretty decent returns.

Assuming Buffett's figure of 2.5 deals per year, with a 3 percent return per deal, and two-times leverage, the expected return would be about 15 percent per year.

Assuming (optimistically) investors do four deals per year (each deal takes several months to finish), leverage two-times, and capture three percent per deal, they would return 24 percent, or about twice the historic return of the U.S. stock market and trumping the performance of most fund managers. Not a bad deal, especially for retail investors.

Incidentally, billionaire hedge fund manager John Paulson and many of the "big guys out of Goldman Sachs" (according to David Clark) started their career in stock arbitrage

by IBTimes