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  • Writer's pictureWilliam Webster

Carry Trades

Carry trades are frequently used to beat markets. They involve buying an asset that has a higher return than the cost of finance. Profits accrue when markets go up or sideways. Losses only arise when markets fall. Winning two times out of three is clearly very attractive. But it has its risks.

You may have noticed that in November 2012 the Bank of England handed some £11bn to the Treasury because the Gilts held by the Bank had an income that exceeded their funding cost. This sounds very much like the results of a carry trade. Of course the Old Lady isn’t alone in undertaking creative monetary policy. Indeed some central banks seem to want to go much further and purchase all sorts of assets in order to get economies moving. Are central banks moving into sovereign wealth fund territory?

Perhaps if we asked a simple question it could throw some light onto an area of markets that seems to be far from transparent.

How important is it to the central bank that it reports a profit on its operations?

As any trader will tell you that once you start to engage in any sort of profitable series of transactions the process quickly becomes addictive.

In the world of commercial banking this is tempered by limits on (market) risk. However in Central Banking these seem never to be discussed. Am I alone in thinking this is odd? Maybe for some reason they just aren’t relevant but I have my doubts.

If you buy a pile of £375bn Gilts with say a duration of 7 years that gives you a £26 bn loss for ever 1% increase in interest rates. And I’m pretty sure there isn’t a matching swap position that offsets this.

You may think it doesn’t matter after all the Bank could just sit on the Gilts until maturity. Provided its funding rates remain low any mark-to-market loss isn’t realised. This is true. But what happens if rates rise? You get a loss and it doesn’t matter whether you use accrual or MTM.

Is it not time to ask more questions about how things work?

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