You’ve probably heard the talking heads on CNBC chattering about this currency play. You’ve probably read about this investment “unwinding” or “being back on” in the Wall Street Journal, or in Bloomberg.

And I’m certain you’ve read about this trade here in the A-Letter – the infamous currency play, known as the “carry trade.”

But still with all this publicity, carry trades remain a mystery to most mainstream investors. Even the carry trade basics – including what it is and the mechanics of placing this trade – elude most investors.

So let me take just a moment to explain what a carry trade is – and why this one trade has been behind some of the most explosive trends in the currency markets for years. Also, I’ll explain why this one trade is about to come undone this year and create some explosive profit opportunities if you’re positioned correctly.

It’s Really So Easy: Borrow, Convert, Reinvest

Though commentators can make this sound complicated, it’s not. Think of it as a simple three-step process and I think you will have the mechanics of a carry trade nailed.

Three-step process that defines a carry trade:

1. Borrow the low cost currency i.e. low interest rate currency
2. Convert the borrowed currency into currency of your choice
3. Reinvest into:

• Deposits of other high yielding currencies
• Stocks
• Bonds
• Commodities
• Real Estate
• Derivatives
• You Name It…

The currency you borrow in step one is often called your “carry trade currency” or your “funding currency.” That’s because this borrowed currency gives you the funds to reinvest as defined in step three. So keep in mind that “carry” and “funding” currency is often used interchangeably in financial literature.

Okay. The process looks easy enough, but why is it, or why was it, so popular? The reason is because it was profitable. It’s very enticing to be able to borrow inexpensively, reinvest and immediately achieve a much higher return. There’s lots of money to be made on the spread…

Spread = Return on Investment in Higher Yielding Assets – Borrowing Cost

…or at least that’s the theory.

For example, say you borrow at 1% then turn around and reinvest the proceeds at 6%. You’ve just earned yourself a quick 5% return without much work. This of course assumes the asset yielding 6% in this example holds its value. If the asset you buy with the carry proceeds falls in value, you have a capital loss. Thus it eats away at the spread that once looked so enticing.

In fact, this is where the problem comes in with the carry trade – it’s based on simplistic assumptions. But incredibly, these simple assumptions didn’t stop fund managers and institutions across the globe from borrowing trillions of dollars to reinvest those assets. And they add massive leverage to boot.

Three Things a Carry Trade Needs to Grow and Thrive

You need to have three major criteria (which are assumptions when projected into the future) for the carry trade to be of any significance:

1. Low borrowing rates from a major central bank – as highlighted above, it comes down to perceived profitability of borrowing cheap and buying or lending at higher rates to achieve the spread. But for a global carry trade to take wing and fly there must be a major global central bank behind the trade (Bank of England, European Central Bank, The Fed, Bank of Japan, etc.). For example, if the central Bank of Zimbabwe were offering 0.5% interest rates, they could not realistically produce enough loans to make it significant. Not to mention they have absolutely no credibility when it comes to monetary policy and a stable currency.

2. Low volatility or weakness in funding currency – if the currency you borrow weakens, or at least remains stable, then your risk is limited to the return available where you invested the proceeds. If the currency you borrow begins to appreciate in value relative to the investment you purchased, then profits begin to fall.

3. Low volatility or strength in invested asset class – As long as the asset class you bought e.g. other currencies, stocks, bonds, etc. with the borrowed proceeds increase in value faster than the underlying borrowed currency, the trade is profitable. But if the assets you bought start to decline in value on a relative basis, your losses can mount quickly.

So there you have it. It’s a straightforward process. And if the funds and institutions didn’t bet so much money on such simplistic assumptions, the carry trade would be relatively innocuous. Unfortunately, not only did they bet big by borrowing trillions, but they turned around and “leveraged it up” many times over. In other words, they used margin to supercharge their carry trade borrowings so they could buy more stuff. After all, it was working for a long time so why change?

Back When All Assets Were Soaring…

From 2001 through most of 2007 almost all asset classes were moving higher and higher in virtual lockstep. Not only that, the volatility of the move was extremely low.

Stocks, gold, and crude oil all moved up together through June of 2007. Thus, we had a happy credit induced bubble ridding merrily higher.

But the game changed come July 2007 – dramatically. The markets bit back, proving what Milton Friedman told us many years ago, “There is no such thing as a free lunch.”

Stay tuned…I’ll give you the full story on how the game has changed tomorrow.

JACK CROOKS, Editor of The Money Trader and World Currency Options

P.S. Tomorrow I’ll tell you why the carry trade currencies rocketed higher and why the new era of the great unwind could change the game for a long time to come and set the stage for some excellent long-term currency trading opportunities. Or you can read my FREE report right now to get all the details on this explosive new trend.