Mini Case: Emerging Market Carry Trades Essays Examples

Mini Case: Emerging Market Carry Trades

The world faced the economic crisis at different period of time. After the global economy suffered the depression arising from the credit crisis in 2008, the governments of America and European country injected a huge quantity of capital in their economy or financial system. During the period of crisis, the central bank of Europe and America reduced their interest rate to the lowest possible level. This step was taken so that they could maintain the certain liquidity level in the market so that the weak banking system of the country would not fall into the prey of credit crisis dragging the whole economy into problem. In addition to this, the another objective of the government in maintaining the low interest rate was to provide the liquidity to the banking system whenever they needed so that these banks could inject the liquid cash into the economy through various investment and loan schemes. This could prevent the economy from being worst and save the country. Due to these reasons, the interest rate was so low in the traditional core markets of USD and EUR.
There are the different reason that makes this “emerging market carry trade” so different from traditional forms of uncovered interest arbitrage. It is very common that the exchange rate of the different currency fluctuates with time. According to the case, the current INR/EUR is 60.4672/EUR. But, it is also usual that the spot exchange rate of INR/EUR appreciates and reaches INR 56/EUR. This kind of situation will produce a very high abnormal profit when someone exchanges EUR for INR and then INR back to EUR. The main purpose of this strategy is to earn an abnormally high profit when the Indian currency appreciates as compared to the Euro. But, on the other hand, the carry trade strategy is concentrated on earning profits that arise because of difference in interest rate between the currencies of two countries. Additionally, the fact that makes it significantly different is that the Japanese Yen was normally used to get the credit facility at the cheap interest rate. The yen obtained at the cheap rate of interest was then exchanged for US dollars or euro. US dollar and Euro, thus obtained was then invested in the country where the interest rate is very high. However, now the scenario has now changed differently. Due to the credit crisis in Europe and America, these countries have lowered their interest rates. Due to this fact, Yen is no longer the currency to obtain cheap credit. Now, US dollars and the euro have arisen as the major currencies to obtain cheap credits. The American dollars and euro are obtained at a low cost and then converted to the currencies of the countries whose economy is growing rapidly. The investment made in these emerging economies have higher growth rate and these economies provide higher interest rate. Due to this, the investor can earn a higher profit. In other words, we can say that the “carry trade” will be beneficial to the investor or speculator by getting the higher interest rates and the appreciation of the currency of emerging economies combined. The main reason for this situation is the slower economic growth that the United States of America and the European region is experiencing as the result of the economic crisis that the global economy faced starting from 2008. But, on the other hand the emerging economies of the world like India, China, Brazil, South Africa and Brazil are proving themselves as the best place to invest in their fast growing economy and high interest rate. The investors are attracted by these fast growing economies, and they have made the considerable amount of investment in these countries. So, these countries are getting the very high benefits in terms of employment, revenue, tax and many other economic aspects that come from the foreign direct investments made in the country.
The debt market in the Eurozone and the United States of America at present faces the extremely low rate of interest while the level of debts is very high. Due to the low-interest rate, anyone can borrow the debt at the cheaper rate in USD or EUR. The borrowed fund can be invested in other countries with different interest rate where the interest rates are more favourable and provide a higher return on investment. The investor who wants to earn profit would short sell USD or EUR to buy the currency of a country, which have the possibility of quick appreciation with rapid growth and low inflation. With the passage of time, the currency of these countries will show the strong appreciation, and this causes the value of USD or EUR to depreciate making these currencies weaker. So, when the investor has to exchange the currency back to USD or EUR, then the investor will get more USD or EUR for the currency purchased previously. This shorting of USD or EUR will let the borrower realize the high profit. So, many investors are shorting the dollar and the euro.