Currency Carry

Trade
Arpit Gupta 11B
Harshit Garg
Serah Issac 43 B
Shilpi Gupta 45B

 Carry Trade is a strategy in which an

investor sells a certain currency with a
Basics of Carry Trade:
relatively low interest rate and uses
Funding Currency
the funds to purchase a different
Currency with low interest rates
currency yielding a higher interest
rate
A trader using this strategy attempts
Target Currency (or investing currency)
to capture the substantial difference
Currency with high rate interest (high yield
between the rates
asset)
Thecarryof anasset is thereturn
obtained from holding it
Carry to risk Ratio
Adjusts the interest rate differential by the risk
Example: a trader borrows 1,000
of future exchange rate movements, where the
Japanese yen from a Japanese bank,
expected
volatility
(implied
by
foreign
converts the funds into U.S. dollars
exchange options) of the relevant currency
and buys a bond for the equivalent
pair is used as a proxy for this risk
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

Trader borrows
Yen at
0.1%
Yen is the
funding currency

Converts to
Dollar and
invests in US
bonds

Bond 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 losses
To 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
investment
In 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 slide

A 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,

To escape currency volatility, the trader could hedge using derivative products:

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 differential
For 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 38.775

Options Buy a PUT Option on the target currency to lock in the exchange rate
and there by reduce currency rate volatility
Example, 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)

INTRODUCTION

RISKS

HEDGING

IMPACTS

YEN CARRY
TRADE

CONCLUSIO
N

Related to the stock

markets

The carry trade and stock markets are positively related

because they both reflect investors risk appetites
High risk appetites induce investors to invest in both
markets, and low risk appetites result in selling stocks
and unwinding carry trades

Unwinding resulting to
plunging of asset prices

Appreciation of funding currency leads to FIIs unwinding

their positions and thereby having an adverse impact
on the stock markets and can also result in plunging
asset prices

Global economy

The global economy also gets severely affected, as the

collapse in asset prices affects consumer confidence
and business sentiment, and exacerbated an economic
slowdown
Nations whose currencies were heavily involved in the
carry trade (such as Japan) can face economic
headwinds, as an unusually strong domestic currency
can render exports uncompetitive

INTRODUCTION

RISKS

HEDGING

IMPACTS

YEN CARRY
TRADE

CONCLUSIO
N

History
First modern yen carry trade occurred in the late
1980s.
Many traders borrowed yen to invest in the muchhigher 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.

Source : Financial Times

INTRODUCTION

RISKS

HEDGING

IMPACTS

YEN CARRY
TRADE

CONCLUSIO
N

During 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,Source
and: Financial
otherTimes

INTRODUCTION

RISKS

HEDGING

IMPACTS

New trends:
Dollar carry trade
With 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 20042007.
Worldwide, over $9 TRILLION in borrowed US Dollars
that has been ploughed into risk assets.
Swiss Franc Carry Trade
Lately 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

YEN CARRY
TRADE

CONCLUSIO
N

Carry trade in Yen &

AUD:

INTRODUCTION

RISKS

HEDGING

IMPACTS

YEN CARRY
TRADE

CONCLUSIO
N

As 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.
Source : Financial Times

INTRODUCTION

RISKS

HEDGING

IMPACTS

YEN CARRY
TRADE

CONCLUSIO
N

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:
(1) 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 time
Started 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 tolerance
The 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 trades
At the same time, the reversal of carry trades boosted the yen further, which drove even
more carry traders to liquidate their positions

INTRODUCTION

RISKS

HEDGING

IMPACTS

YEN CARRY
TRADE

CONCLUSIO
N

Carry trade in Yen &

A AUD:
strategy of going short
in the (low-interest rate)
and long in the (high
interest rate) A$ made a
little money every month
2001-08
The 5% interest
differential was not
offset
by any depreciation of
the A$ during these
years
Suddenly in 2008, the
strategy of going short in
and long in A$ lost a
lot of money, as risk
Speculators began to be hit with margin calls as prices of practically every
asset began
sliding.
concerns
rose sharply,
Hence, the assets had to be sold atfire-saleprices. Traders had to repay
loans even
thetheir
carryyen
trade
as the yen was surging which made the currency even stronger. In addition,
the interest
unwound,
and therate
A$

INTRODUCTION

RISKS

HEDGING

IMPACTS

YEN CARRY
TRADE

CONCLUSIO
N

Limitations:

Why can we not enjoy the benefits of the interest rate

differential in our daily life?

Government Regulations:
Restriction on capital flows in the potential target currencys country may hamper currency carry
trade. For example, there are capital flow restrictions in many emerging economies

Transaction Costs:
High costs like brokerages, hedging cost, bid-ask spread will eat into the profit of the trader and hence,
make the carry trade not feasible

Managed Exchange Rate:

Lack of pure flexible exchange rates distorts the prediction of future exchange rates
thereby making it difficult to enter into profitable positions

INTRODUCTION

RISKS

Best Way:

HEDGING

IMPACTS

YEN CARRY
TRADE

CONCLUSIO
N

The best way to carry currency trade can be via BASKET

When 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
them
With 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 basket
This 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 sizes
The key with a basket is to dynamically change the portfolio allocations based
upon theinterest rate curveand monetary policiesof the central banks

INTRODUCTION

RISKS

HEDGING

IMPACTS

YEN CARRY
TRADE

CONCLUSIO
N

Bibliography:
NYU - CarryTradesCurrencyCrashes

https://economics.stanford.edu/files/Tosborvorn_HThesis2010.pdf
http://www.investopedia.com/articles/forex/07/carry_trade.asp
http://www.investopedia.com/articles/forex/09/credit-crisis-carry-trade.asp
https://
www.khanacademy.org/economics-finance-domain/core-finance/money-and-banking/curren
cy-tutorial/v/carry-trade-basics
www.financialtimes.com-articles
Getting 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
University

Carry Trades and Currency Crashes by

Markus K. Brunnermeier, Princeton University, NBER, and CEPR
Stefan Nagel, Stanford University and NBER
Lasse H. Pedersen, New York University, NBER, and CEPR