Emerging Market Carry Trades

Emerging Market Carry Trades Incredibly low interest rates in both the United States and Europe, accompanied by dim economic performance and continuing concern over fiscal deficits, has led to a new form of carry trade which shorts the dollar and euro. The carry trade has long been associated with Japan and the relatively low interest rates which its financial community has made available to multinational investors. A form of uncovered interest rate arbitrage (UIA), the Japanese carry trade was based on an investor raising funds in Japan at low interest rates and then exchanging the proceeds for a foreign currency in which the interest rates promised higher relative returns. Then, at the end of the term, the investor could potentially exchange the foreign currency returns, plus interest, back to Japanese yen to settle the obligation and also, hopefully, a profit. The entire risk-return profile of the strategy, however, was based on the exchange rate at the end of the period being relatively unchanged from the initial spot rate.

Emerging Market Carry Trades The global financial crisis of 2007-2009 has left a marketplace in which the U.S. Federal Reserve and the European Central Bank have pursued easy money policies. Both central banks, in an effort to maintain high levels of liquidity and support fragile commercial banking systems, have kept interest rates at near-zero levels. Now global investors, those who see opportunities for profit in an anemic global economy, are using those same low-cost funds in the U.S. and Europe to fund uncovered interest arbitrage activities. But what is making this “emerging market carry trade” so unique is not the interest rates, but the fact that investors are shorting two of the world’s core currencies, the dollar and the euro.

Exhibit 1 The Euro/Indian Rupee Carry Trade Global investors are finding it profitable to borrow in the US or Europe – in dollars or euros -- and invest those funds in higher yielding interest currencies like the Indian rupee Exhibit 1 The Euro/Indian Rupee Carry Trade

Exhibit 1. Emerging Market Carry Trades An investor borrows EUR 20 million at an incredibly low rate, say 1.00% per annum or 0.50% for 180 days. The EUR 20 million are then exchanged for Indian rupees (INR), the current spot rate being INR 60.4672 = EUR 1.00. The resulting INR 1,209,344,000 are put into an interest bearing deposit with any of a number of Indian banks attempting to attract capital. The rate of interest offered, 2.50%, is greater than that available in the dollar, euro, or even yen markets. But the critical component of the strategy is not to earn the higher rupee interest (although that does help), it is the expectations of the investor over the direction of the INR per EUR exchange rate.

Emerging Market Carry Trades: Case Questions Why are interest rates so low in the traditional core markets of USD and EUR? What makes this “emerging market carry trade” so different from traditional forms of uncovered interest arbitrage? Why are many investors shorting the dollar and the euro?

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