Case Number Two: Emerging Markets Carry Trades

The weak economic outlook for the euro zone is the primary factor driving the change in that trade. Minor differences in interest rates between the euro and either the dollar or the Japanese yen are less important right now, strategists said. Rates in the U.S. and Japan are near 0%, while they are at 1% in Europe. - Euro Becomes Increasingly Popular Choice to Fund Carry Trades, The Wall Street Journal, December 21, 2010.

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 most unexpected outcome: 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.

The global financial crisis of 20072009 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.

Consider the strategy outlined in Exhibit 1. 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 not particularly high, but 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.

The European economy yielded very weak economic growth in 2010, and all indications were that 2011 would not be much better. Low interest rates, although expected to persist, had not done much to support the euros value. Like the dollar, many forecasts were for the euro to fall against many of the worlds currenciesincluding the Indian rupee. The Indian economy, however, had been growing rapidly; in fact, nearly too fast. Inflationary pressures had kept inflation for 2010 at just under 10%, and it was expected to remain at 7% or higher throughout 2011.

The State Bank of India, Indias central bank, was expected to tighten monetary growth to fight inflationary pressures, sending rupee interest ratesand the rupee itself, higher on world markets. In the exhibit the investor is shown expecting a spot rate at the end of the 180-day arbitrage position at INR 56.00/EUR. The expected yield on position, a whopping 8.83% (EUR 1,765,371 profit on an initial investment of EUR 20 million). An extremely attractive rate of return in a global marketplace of sub-5% investment yields.

Required Questions: Four Marks for Each Question.

1. Why are interest rates so low in the traditional core markets of USD and EUR?
2. What makes this emerging market carry trade so different from traditional forms of uncovered interest arbitrage?
3. Why are many investors shorting the dollar and the euro?

EXHIBIT 1 The Euro/Indian Rupee Carry Trade Start End Investor borrows EUR 20,000,000 at 1.00% interest 1.00% per annum or 1.005 for 180 days EUR 20,000,000 21,865, 371 EUR 1,765,371 INR 60.4672/EUR 180-day period INR 56.00/EUR INR 1,209,344,000 2.50% per annum or 1.0125 for 180 days INR 1,224,460,800