Swiss Franc Carry Trade and Safe-Haven Rally Risk

Swiss Franc Carry Trade and Safe-Haven Rally Risk

Sub: Eco

Sec: External sector

• Swiss Franc as a Funding Currency:
  • The Swiss franc (CHF) is being increasingly used by investors to fund carry trades, a strategy where traders borrow low-interest currencies and swap them to invest in higher-yielding assets.
  • This is due to the decline in appeal of Japan’s yen, especially after the yen’s value rallied following weak U.S. economic data and a surprise rate hike by the Bank of Japan.
• Swiss Franc’s Interest Rate Environment:
  • The Swiss National Bank (SNB) initiated an easing cycle earlier in the year, keeping the key interest rate at 25%.
  • Comparatively, interest rates in other regions are higher: 25%-5.50% in the United States, 5% in Britain, and 3.75% in the eurozone.
• Safe-Haven Status:
  • The Swiss franc is near its highest value in eight months against the dollar and nine years against the euro. This reflects its status as a safe-haven currency and market expectations for European and U.S. rate cuts.
• Investor Strategy and Risks:
  • Speculators have maintained a $3.8 billion short position against the Swiss franc, indicative of its use in carry trades, while simultaneously moving to a $2 billion long position on the yen.
  • BofA and Goldman Sachs recommend buying sterling against the franc, citing the large interest rate gap between Switzerland and Britain.
  • However, using the Swiss franc as a funding currency is inherently risky, especially due to its safe-haven status, which could lead to rapid appreciation during market uncertainty, potentially wiping out gains from carry trades.
• Potential Central Bank Actions:
  • The SNB is expected to cut rates further in the coming months, which could lower borrowing costs and weaken the franc, making it cheaper for those already borrowing it.
  • The SNB and regulators may intervene to prevent the currency from appreciating further, especially considering the negative impact on exporters.

Currency carry trade

A currency carry trade is a financial strategy where an investor borrows money in a currency with a low-interest rate and uses the funds to invest in another currency with a higher interest rate. The goal is to profit from the difference between the interest rates, known as the “interest rate differential.”

How Currency Carry Trade Works

• Borrowing in a Low-Interest Currency:
  • The investor borrows money in a currency with a relatively low-interest rate. For example, if the interest rate in Japan is 0.1%, an investor might borrow Japanese yen.
• Converting and Investing in a High-Interest Currency:
  • The borrowed yen are then converted into a currency with a higher interest rate, such as the Australian dollar, where the interest rate might be 3-4%.
  • The investor then invests these funds in assets denominated in the higher-interest currency, such as bonds, stocks, or simply depositing it in a high-interest savings account.
• Earning the Interest Rate Differential:
  • The investor earns the difference between the higher interest rate on the investment and the lower interest rate on the borrowed funds.
  • For example, if the investor borrows yen at 0.1% and earns 4% on Australian dollars, the gross profit is 3.9%, before accounting for any transaction costs or exchange rate fluctuations.
• Repaying the Loan:
  • At the end of the investment period, the investor converts the high-interest currency back into the low-interest currency to repay the loan, ideally keeping the difference as profit.

Example of Currency Carry Trade

An investor borrows 1,000,000 Japanese yen at an interest rate of 0.1% per year. The investor converts the yen into Australian dollars and invests it in an Australian bond yielding 4% per year.

If the exchange rate between the yen and the Australian dollar remains stable, the investor will earn a 3.9% profit on the trade.

However, if the Australian dollar depreciates significantly against the yen, the investor could face a loss when converting back to yen to repay the loan.

Risks Associated with Currency Carry Trade

• Exchange Rate Risk
• Interest Rate Risk
• Market Volatility