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Playing the Carry-Trade Game On Forex
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Each foreign currency has a central bank that issues an overnight lending rate. This is a prime gauge of a currency's value. In recent history, low interest rates have resulted in the devaluation of a currency. Many analysts assume this is a function of the carry-trade strategy, employed by many hedge funds. This is a trade where one buys and holds currencies in a high yielding interest rate market, such as the United States, and sells or bor rows money from a foreign country where the currency is in a low-yielding interest rate market, such as exists in Japan. There is a significant risk ex posure to this investment, which requires large capital, or a highly lever aged position from an exchange-rate fluctuation.

Understanding Treasuries: Yield and Price

When I discussed the inverted yield curve and pointed out the discrepancy between the 10- and 2-year notes as shown in Figure 1.6, I wanted to further explain how these instruments work and the relationship to forex. Let's first define what a Treasury bond is and how it works and is priced out.

U.S. Treasury bonds (T-bonds) are by all definitions a loan. Taxpayers are the lenders. The U.S. government is the borrower. The government needs money to operate and to fund the federal deficit, so it borrows money from the public by issuing bonds.

When a bond is issued, its price is known as its “face value.” Once you buy it, the government promises to pay you back on a particular day that is known as the “maturity date.” They issue that instrument at a predetermined rate of interest called the “coupon.” For instance, you might buy a bond with a $1,000 face value, a 6 percent coupon, and a 10-year maturity. You would collect interest payments totaling $60 in each of those 10 years. When the decade was up, you'd get back your $1,000. If you buy a U.S. Treasury bond and hold it until maturity, you will know exactly how much you're going to get back. That's why bonds are also known as “fixed-in come” investments; they guarantee you a continuous income and are backed by the U.S. government. There are also the concepts of yield and price. That is what confuses most investors. It is very simple: When yield goes up, price goes down; and vice versa.

Treasury Bonds, Bills, and Notes

The U.S. government issues several different kinds of bonds through the Bureau of the Public Debt, an agency of the U.S. Department of the Treasury. Treasury debt securities are classified according to their maturities:

• Treasury bills have maturities of 1 year or less.

• Treasury notes have maturities of 2 to 10 years.

• Treasury bonds have maturities greater than 10 years.

Since there are more equity traders in the investment world than there are forex traders, this investment area may attract more participants. If the equity markets are forecast to generate normal to even subnormal returns based on a historical standard for 2006 and beyond, then the appetite for making money may attract the individual investor to trade in the Treasury and forex markets.

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