Carry Trade

By borrowing in one country's currency, performing a Currency Exchange into the other currency, and investing at the higher interest rate. It's called the Carry Trade.

The Carry Trade has significant risks:

• Interest Rates fluctuate (unless you borrow at a contractually fixed interest rate over some term),
• currency exchange rate fluctuations (which can be extremely volatile, relative to the interest rate spread you're profiting from), and
• Credit Risk (your investment might go bad).

Hypothetical example:

 

1. sell 10 year bonds at the U.S. Prime rate of interest (right now, 3.25%)
2. take the dollar proceeds and exchange into the Euro (currency) (paying a percentage currency exchange fee, of course)
3. buy 10 year Greek or Spanish sovereign bonds which are paying 11.43% and 4.36%, respectively
4. interest payments coming back from those investments will be paid in Euros, of course, and you'll pay a currency exchange fee to get them back into dollars, which diminishes your profit because it narrows the spread between the interest you must pay on your debt and the interest you're paid by the bonds you invested in. Plus, if the Euro becomes cheaper than the dollar than it was when you made the investment (which it might: it started at parity with USD, dropped as low as $0.85  and is now around $1.40), you're losing spread there, too.
5. Hope the Greek or Spanish governments don't default on their debt explicitly (formally) over the 10 year period (there's a reason why their bonds are yielding so high (paying so much interest)) ... or, if the credit risk is too high for you, sell the bonds for whatever they'll fetch in the bond markets, and "unwind your trade" (convert back all the money from Euros to Dollars, and pay off the bonds you sold, if they're "callable" prior to maturity).

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