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(solution) CASE STUDY 14-5 Carry Trade Earlier defined, carry trade is the strategy in which an investor...

CASE STUDY 14-5 Carry Trade Earlier defined, carry trade is the strategy in which an investor borrows a low-yielding currency and lends (invests in) a higher-yielding currency. The risk is that if during the investment period the higher-yielding currency depreciates vis-a-vis the ` lower-yielding currency by a higher percentage than the positive interest differentials, the investor would lose money. For example, suppose that in a “yen carry trade” the investor borrows yens from a Japanese bank at 1 percent interest, exchanges the yens for U.S. dollars at the prevailing dollar/yen exchange rate, and then buys a U.S. bond paying, say, 4 percent interest. The investor would earn 3 percent net on her or his investment—so long as the dollar/yen exchange rate does not change during the period of the investment. If the dollar appreciated with respect to the yen, the investor would earn that much more. If, on the other hand, the dollar depreciated with respect to the yen during the investment period, the investor would earn less, break even, or incur a loss. Specifically, if the dollar depreciated by less than 3 percent with respect to the yen during the investment period, the investor would earn that much less. If the dollar depreciated by exactly 3 percent, the investor would break even (assuming no transaction costs). If, on the other hand, the dollar depreciated by more than 3 percent, the investor’s loss would equal the difference between the rate of the dollar depreciation and the positive interest differential in favor of the dollar. Thus, the big risk in carry trade is the uncertainty of exchange rates. Actually, the gains or losses from carry trade will be much greater than indicated above because of leveraging (i.e., because the investor buys the U.S. bond on margin—puts down only a small fraction, usually 10 percent, of the bond price). In this case, the gains or losses would be amplified tenfold. In theory, according to uncovered interest rate parity, carry trades should not yield a predictable profit because the difference in interest rates between two currencies should equal the rate at which investors expect the low-interest-rate currency to appreciate with respect to the high-interest-rate one. Carry trades, however, tend to weaken the currency that is borrowed, because investors sell the borrowed money by converting it to other currencies. In fact, the carry trade is often blamed for rapid depreciation of the low-yielding currency and appreciation of the higher-yielding currency, thus increasing exchange rate volatility. The U.S. dollar and the yen have been the currencies most heavily used in carry trade transactions since the 1990s, with the yen being the low-rate currency and U.S. dollar bonds being the higher-yielding asset. At its peak, in early 2007, the yen carry trade was estimated to be about $1 trillion. That trade largely collapsed in 2008 as a result of the rapid appreciation of the yen. This created pressure to cover debts denominated in yen by converting foreign assets into yen—which led to further yen appreciation. Exchange rate volatility often leads to carry trade unwinds, the largest of which was the 2008 one, and that contributed substantially to the credit crunch that caused the 2008 global financial crisis.


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Sep 13, 2020





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