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Assignment No.1/ Week 2: Mini Case: Emerging Market Carry Trades

This carry trade involved borrowing 20 million euros at 1% interest and converting to Indian rupees at 1.25 billion rupees to invest at 2.5% interest. However, the rupee strengthened from 60.4672 to 71.0784 rupees per euro, eliminating profits and resulting in a 2.76 million euro loss when converting rupees back to euros. While emerging markets offer higher rates, uncovered interest arbitrage carries high risk from unfavorable spot rate movements, making this a risky and unwise carry trade in hindsight.

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118 views

Assignment No.1/ Week 2: Mini Case: Emerging Market Carry Trades

This carry trade involved borrowing 20 million euros at 1% interest and converting to Indian rupees at 1.25 billion rupees to invest at 2.5% interest. However, the rupee strengthened from 60.4672 to 71.0784 rupees per euro, eliminating profits and resulting in a 2.76 million euro loss when converting rupees back to euros. While emerging markets offer higher rates, uncovered interest arbitrage carries high risk from unfavorable spot rate movements, making this a risky and unwise carry trade in hindsight.

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Assignment no.

1/ week 2

Mini case: Emerging Market Carry Trades

1. Why are interest rates so low in the traditional core markets of USD and EUR?
the Central Banks of both the United States of America and Europe kept a low level of
interest rates during crisis times to secure a certain level of liquidity in the markets and to
support fragile banking system
moreover, the desired goal of these strategies was to provide cheap liquidity for instances
for banks, which were expected to forward a decent part of this liquidity to the economies
through credits or investments => low cost funds

2. What makes this "emerging market carry trade" so different from traditional forms of uncovered
interest arbitrage?
it is unusual that the spot exchange rates INR/EUR strengthens from INR 60.4672/EUR to INR
56/EUR, which will lead to an extra profit when changing INR back into EUR
this strategy is aimed at earning an extremely high return on the appreciation of the Indian
rupee towards the Euro, whereas usually the carry trade is focused on gaining profit on
interest rate differences between the two currencies
furthermore, what makes it considerably different is the fact that normally the Japanese Yen
was the platform for gaining cheap credit and exchanging the Yen into USD or EUR, which is
then invested at better interest rates; but what can be seen now is that the main currencies
EUR and USD provide cheap credits which are converted into currencies of emerging markets
like India or China, as they offer more favourable interest rates for investments

3. Why are many investors shorting the dollar and the euro?
The US and the Euro zone currently have very low interest rates and high debts. As it is
possible to borrow cheap in EUR or USD and to invest in other currencies at more favourable
interest rates, many investors short the EUR or USD and buy e.g. currencies of emerging
markets, which show a strong economic growth and decent inflation. Thus, these currencies
are expected to strengthen, which will cause a weaker EUR or USD and better exchange
rates when changing the emerging market currencies back into EUR or USD. Through this,
high profit is realized.
Additional questions:

4. Was the carry trade profitable? Show calculation of result in EUR.


Given data: 20 Mio. Euro, borrowed at 1,0% per annum; exchange rate: INR 60.4672/EUR;
could invest INR at 2,5% per annum
Calculations:
60.4672
o 20 . 1
= 1,209,344,000

o 1,209,344,000 1,025 = 1,239,577,600


o Current exchange rate (10.05.2013, 14:30): INR 71.0784/EUR (Bloomberg 2013)
0.0141
1,239,577,600 1
= 17,439,582.21

Conclusion: final amount of Euro: EUR 17,439,582.21; amount needed to repay loan: EUR
20,200,000 -> loss of EUR 2,760,417.79

5. Was it a wise decision to enter in this carry trade a year ago? Why (not)?

It was not a wise decision to enter this carry trade a year ago. Even though an INR investment seems to
offer a higher interest rate and thus offset the borrowing interest rate, the change of the spot rate from
INR 60.4672/EUR to INR 71.0784/EUR results in an elimination of the profit and an additional loss
through an unfavourable spot rate development (see above). Thus, this shows the high risk of on UIA, as
it is completely dependent on the development of the currency pairs spot rate (no forward rate is used).

References:

Bloomberg EURO-INDIAN RUPEE Exchange Rate 2013 [online], Available from:


http://www.bloomberg.com/quote/EURINR:CUR [Accessed: 10.5.2013]

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