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Carry Trade & Euro Credit Crisis GLOBAL FINANCE TERM PAPER PRESENTATION APARAJITA SINHA Roll No 622 JONATHAN SYIEMLIEH Roll No 612
19

Global Finance PPT

Apr 03, 2015

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Page 1: Global Finance PPT

Carry Trade & Euro Credit Crisis

GLOBAL FINANCE TERM PAPER PRESENTATION

APARAJITA SINHA Roll No 622JONATHAN SYIEMLIEH Roll No 612

Page 2: Global Finance PPT

CARRY TRADE – AN OVERVIEW

“Carry” is defined as the difference between the return on securities held and the financing costs, and “carry trade” refers to institutions and businesses taking advantage of this differential

– The OECD Economic Outlook

Page 3: Global Finance PPT

EXAMPLE

Page 4: Global Finance PPT

HOW A CARRY TRADE IS SET UP

Environment for Carry Trade

Suitable Market Conditions

Selection of appropriate currency pair

THUMB RULE: Traders generally seek to buy currencies with high interest rates and seek to

short currencies offering low interest rates

Page 5: Global Finance PPT

Continued…

Some currency pairs that are usually selected to apply the carry trade strategy are GBP/JPY GBP/CHF AUD/JPY EUR/JPY CAD/JPY USD/JPY

Page 6: Global Finance PPT

CARRY TRADE & INTEREST RATE PARITY

Carry Trade finds its basis in the Interest Rate Parity Condition

Uncovered Interest Rate Parity Condition:

The difference in interest rates between two countries should equal the rate at which investors expect the low-interest-rate currency to rise against the high-interest-rate currency

Page 7: Global Finance PPT

Continued…

Uncovered Interest Rate Parity (UIP) Equation

(i1 – i2) = E (e) where i1: interest rate of country 1

i2: interest rate of country 2 E(e): expected rate of change in the

exchange rate

That is, if we assume that the interest rate in America is 10% and the interest rate in Canada is 15%, then according to UIP, the Canadian dollar is expected to depreciate against the American dollar by approximately 5%

Page 8: Global Finance PPT

Continued…

However, Carry Trades weaken the currency that is borrowed, because investors sell the borrowed money by converting it to other currencies. This violates the UIP Condition.

This gives rise to profitable opportunities in carry trade.

Page 9: Global Finance PPT

BENEFITS & RISKS OF CARRY TRADE

BENEFITS

Good strategy for investment when there is financial stability all over the globe

Part of currency trading market

RISKS

Depends on the very uncertain exchange rates

High level of leverage involved in carry trade transactions (can be avoided through hedging)

Page 10: Global Finance PPT

CARRY TRADE & CURRENCY CRASHES

Research Paper – March 2008

Markus K. Brunnermeiery - Princeton University, Stefan Nagelz - Stanford University and Lasse H. Pedersenx - New York University

This paper studied crash risk of currencies for funding-constrained speculators in an attempt to shed new light on the major currency puzzles

Page 11: Global Finance PPT

FindingsCarry Trades subject to crash

risk

Exchange rate

movements between

high interest rate and

low interest

rate currencies

- negatively

skewed

Negative skewness is due to sudden

unwinding of carry

trades

Carry-trade losses reduce future crash

risk, but increase the price of crash

risk

Carry trades can be

destabilizing when strategic complementarities

arise

Page 12: Global Finance PPT

Empirical Study

Time Series Data on the exchange rates of 8 major currencies, relative to the US dollar

Calculated realized skewness from daily data within quarterly time periods

High interest-rate differentials predict negative skewness, that is carry trade returns have crash risk

High interest-rate differentials predict positive speculator positions, consistent with speculators being long the carry trade on an average

Page 13: Global Finance PPT

Crosssection of skewness (Panel A) for different interest differentials i* - i

Page 14: Global Finance PPT

EURO CREDIT CRISIS

Different economic structures• Economic Conditions in each member

country of the EU diff; common Central Bank / Monetary Policy not suitable

Rising Fiscal Deficit• Cause of growing concern, instability• PIIGS countries

Carry Trade in Euro• Vulnerability of Eurozone• Lowering of interest rates• Carry Trade with USD

Page 15: Global Finance PPT

CARRY TRADE IN EURO - TIMELINE

Jan

• Deteriorating sentiment over the fiscal health of some European countries (Greece)

• € fell below $ 1.39 for the first time in six months

• ECB continued to maintain low interest rates – further pressure on €

Feb

• € plunged to an eight-month low as a result of the sovereign – debt panic (PIIGS) – low cost of short-term borrowing

• Currency Speculators & Arbitragers jump to grab this Carry Trade opportunity

• Greece & Spain tried to push back speculators who wanted to short the € or use it in carry trades, further depressing the already soft currency

• Moderating inflation called for rate hikes in several other commodity currencies (such as the AUD), thus widening the gap between the € and these currencies further

Page 16: Global Finance PPT

Continued…

Mar

• Some of the world’s biggest speculative funds pooled efforts to cause the €’s rate of exchange to plummet down to a parity level with the US$

May

• The € fell the most against the US$ since the collapse of the global credit markets in 2008

• ECB failed to ease concerns that Greece’s fiscal crisis would intensify across the Eurozone

• The € posted its biggest intraday decline against US$

• ECB’s benchmark interest rate at a record low of 1%

• Intense austerity measures announced in Greece

• Growth rate of Eurozone in 2010 Q1: 0.1%Apr

• Volatility in currency exchange rates -> differences in central bank rates didn’t increase fast enough to allow profitable carry trade to continue

• However, the damage had been done

Page 17: Global Finance PPT
Page 18: Global Finance PPT

FUTURE OF THE EURO

France & Germany – main agents of bailouts for the southern European nations

France threatening to quit Eurozone; Germany rumoured to be contemplating the same

To spur their economies, Greece and the other crisis-stricken countries may have to dump the €, since a real depreciation is required to restore competitiveness

€ may remain the currency of only those countries having stronger fiscal and economic foundations

THE FUTURE IS BLEAK!

Page 19: Global Finance PPT

Thank You!