Tuesday, July 05, 2005

Trade the money, not your pride

Safe Haven | Whats next for the Majors...? "Why Asia should be on your list..."
"Country trade balances (the difference between imports and exports) can also affect the profitability of a carry trade. We have shown above that when investors have low risk aversion, capital will flow from the low interest rate paying currency to the high interest rate paying currency. This however, does not always happen. To understand why, think about the situation in the United States. The US currently pays historically low interest rates, yet it attracts investment from other countries, even when investors have low risk aversion (i.e., they should be investing in the high interest rate countries). Why does this occur? The answer is because the US runs a huge trade deficit (its imports are greater than its exports)—a deficit that must be financed by other countries. Regardless of the interest rates it offers, the US attracts capital flows to finance its trade deficit. The point of this example is to show that even when investors have low risk aversion, large trade imbalances can cause a low interest rate currency to appreciate."