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.
 Case background:

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 worlds
core currencies, the dollar and the euro.
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

The exchange rate of INR and Euro 2003-2012

Windows of opportunities, timing

is important!
 Carry trade: Euro and dollars
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
1. Why are interest rates so low in the traditional core markets of USD and
EUR?
Governments and central banks, following the global credit crisis, have injected massive
quantities of capital into their financial systems, driving interest rates near zero.
2. What makes this emerging market carry trade so different from
traditional forms of uncovered interest arbitrage?
This carry trade appears to benefit the investor/speculator on higher yielding interest and
emerging market currencies appreciation, a combined effect. This can be due to the fact that
the US economics and Euro countries suffer relatively slow economic growth due to the
economic crisis starting from 2008, while the major emerging market countries have economies
which are showing economic growth and the benefits of renewed foreign direct investment.
3. Would you recommend this trade to your company/investors and why?
Not if you dont believe an continuous appreciation of Indian Rupees against the world
currency. Timing is important!