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.