Currency Carry Trade

Currency Carry TradeArpit Gupta 11BHarshit Garg Serah Issac 43 BShilpi Gupta 45B1Carry Trade is a strategy in which an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rateA trader using this strategy attempts to capture the substantial difference between the ratesThecarryof anasset is thereturn obtained from holding it

Example: a trader borrows 1,000 Japanese yen from a Japanese bank, converts the funds into U.S. dollars and buys a bond for the equivalent amount. Let's assume that the bond pays 4.5% and the Japanese interest rate is set at 0.1%. The trader stands to make a profit of 4.4% as long as the exchange rate between the countries does not changeBasics of Carry Trade: Funding Currency Currency with low interest rates

Target Currency (or investing currency)Currency with high rate interest (high yield asset)

Carry to risk RatioAdjusts the interest rate differential by the risk of future exchange rate movements, where the expected volatility (implied by foreign exchange options) of the relevant currency pair is used as a proxy for this risk

Trader borrows Yen at 0.1%Yen is the funding currencyConverts to Dollar and invests in US bondsBond pays 4.5% interest and trader profits by 4.4%Dollar is the target currency

A large difference in rates can be highly profitable for the trader, but large exchange rate fluctuations can suddenly swing trades into huge lossesTo protect against such huge possible losses due to these sudden exchange rate fluctuations, hedging is used Ahedgeis an investment position intended to offset potential losses/gains that may be incurred by a companion investmentIn our previous example, we can use some derivatives to nullify the risk of fluctuating exchange rates between JPY and USD, to make sure we gain a profit at the end of all transactions as shown in the next slideA risk in carry trading is that foreign exchange rates may change in such a way that the investor would have to pay back more expensive currency with less valuable currency, potentially incurring a loss on the entire dealTo escape currency volatility, the trader could hedge using derivative products:

Options Buy a PUT Option on the target currency to lock in the exchange rate and there by reduce currency rate volatilityExample, the trader could buy a PUT option by paying a premium, which would provide him the right to sell JPY at an exchange rate of (say) /$ 99.50 , thus resulting a profit of 38.775 (excluding the premium paid for the put option)Forwards/ Futures Enter a forward contract to sell target currency to lock in the current spot rate or a rate not exceeding the interest rate differentialFor Instance : The trader in the previous example could enter into a forward contract at /$ 99.50 This would have resulted in an inflow of (10.45*99.5) = 1,039.775 and a profit of 38.775Source : Financial TimesFirst modern yen carry trade occurred in the late 1980s. Many traders borrowed yen to invest in the much-higher yielding currencies that were participants of the ERM (European Monetary System) mechanism. When the Nikkei and the Japanese real estate market started a long decline in 1990s, many Japanese investors were forced to repatriate their capital from overseas This marked the beginning of the end of the first modern yen carry trade.

History

Source : Financial TimesDuring 2004-08, the yen weakened about 20 percent against the dollar. From the beginning of 2007 to the end of 2009, yen rose a whipping 34%Huge appreciation of yen against USD in addition to the decline interest rate in USA made carry trade difficult. The yen carry trade with the dollar halted in 2008 when the Federal Reserve dropped the Fed funds rate to near zero.After the financial crisis, the trade became less popular as monetary easing in the U.S. and Europe kept interest rates for banks artificially low, increasing the appeal of using the dollar and the euro instead of the yen.However, it is still going strong with currencies such as the Brazilian real, Australian dollar, Turkish lira, and other higher-yielding currencies. For example, many forex traders borrow near-zero yen to buy Australian dollars which have a 4.5% return.

Carry trade in Yen & AUD:New trends: Dollar carry tradeWith low interest rate in US, easy and readily available funds, investors started borrowing huge sums of money in dollars to purchase higher-yielding assets overseas in carry trades to achieve better returns. Analysts say that oil collapse in 2014 is predicated by one major event: the explosion of the US Dollar carry trade. At the height of the yen carry trade, transactions were said to have hit $1 trillion, accumulated from 2004-2007. Worldwide, over $9 TRILLION in borrowed US Dollars that has been ploughed into risk assets.

Swiss Franc Carry TradeLately the Swiss franc has started behaving more like the Japanese yen The reason: Switzerlands extremely low interest rates of 2.25%. Currency traders are borrowing massive amounts of Swiss francs, then investing that money in countries like Iceland, where the money earns higher interest rates of 14.25%

Source : Financial TimesAs confidence returned to global markets in 2013 , investors appeared to use the cheap yen once again to fund investments in risky assets.The yen had lost 13 percent of its value against the U.S. dollar, hitting a 2-1/2 year low on expectations ofaggressive monetary policyfrom Japan.The fact that the rupee has appreciated 8.14% against the yen between October 16 last year and January 6 suggests interest arbitrage between India and Japan is growing. During the same period, the rupee has weakened 2.78% to 61.57 against the US dollar, mirroring weakness in other major currencies against the greenback.In what ways were yen carry trades responsible for the global market sell-off in early 2007?Yen carry trades relies on four contributing factors:Japanese rates are super low; (2) the yen does not appreciate much; (3) investors have high risk tolerance; and (4) foreign assets offer much higher returns. The instability of carry trades arises because most of these conditions are interdependent and susceptible to abrupt changes. More importantly, a vicious circle can develop such that all the operating factors can turn against investors at the same timeStarted with the prospect of rising rates in Japan, the yen got stronger. Higher Japanese rates and the stronger yen reduced not only the profitability of carry trade and also investors risk toleranceThe reduced profitability, coupled with lower risk appetites, triggered a rapid unwinding of some carry trades, thereby causing asset prices to fall around the globe. Self-fulfilling, the resulting market volatility in turn raised risk aversion and further discouraged carry tradesAt the same time, the reversal of carry trades boosted the yen further, which drove even more carry traders to liquidate their positionsIn sum, higher Japanese rates, stronger yen, lower risk appetites, and declining prices of foreign assets all worked against yen carry trades and worsened the sell-offA strategy of going short in the (low-interest rate) and long in the (high interest rate) A$ made a little money every month 2001-08The 5% interest differential was not offsetby any depreciation of the A$ during these yearsSuddenly in 2008, the strategy of going short in and long in A$ lost a lot of money, as risk concerns rose sharply, the carry trade unwound, and the A$ plunged against Carry trade in Yen & AUD:

Speculators began to be hit with margin calls as prices of practically every asset began sliding. Hence, the assets had to be sold atfire-saleprices. Traders had to repay their yen loans even as the yen was surging which made the currency even stronger. In addition, the interest rate advantage enjoyed by higher-yielding currencies began to dwindleLimitations: Why can we not enjoy the benefits of the interest rate differential in our daily life?Best Way: The best way to carry currency trade can be via BASKETWhen it comes to carry trades, at any point in time, one central bank may be holding interest rates steady while another may be increasing or decreasing themWith a basket that consists of the three highest and the three lowest yielding currencies, any one currency pair only represents a portion of the whole portfolio; therefore, even if there is carry trade liquidation in one currency pair, the losses are controlled by owning a basketThis is actually the preferred way of trading carry for investment banks and hedge funds. It may be a bit tricky for individuals because trading a basket would naturally require greater capital, but it can be done with smaller lot sizesThe key with a basket is to dynamically change the portfolio allocations based upon theinterest rate curveand monetary policiesof the central banksBibliography:NYU - CarryTradesCurrencyCrasheshttps://economics.stanford.edu/files/Tosborvorn_HThesis2010.pdfhttp://www.investopedia.com/articles/forex/07/carry_trade.asphttp://www.investopedia.com/articles/forex/09/credit-crisis-carry-trade.asphttps://www.khanacademy.org/economics-finance-domain/core-finance/money-and-banking/currency-tutorial/v/carry-trade-basicswww.financialtimes.com-articlesGetting Carried Away: How the Carry Trade and Its Potential Unwinding Can Explain Movements in International Financial Markets by Jeffrey Frankel, Harpel Professor of Capital Formation and Growth, Kennedy School of Government, Harvard UniversityCarry Trades and Currency Crashes byMarkus K. Brunnermeier, Princeton University, NBER, and CEPRStefan Nagel, Stanford University and NBERLasse H. Pedersen, New York University, NBER, and CEPR