A bet on interest rates

What is a carry trade?

Carry trade refers to the trade where an investor borrows funds in a market where the interest rate is relatively low and then invests the borrowed money in a market where the interest rate is higher.

Why are investors attracted to the trade?

It helps investors realise better returns by arbitraging on the interest rate differentials. For example, a foreign portfolio investor may borrow in the U.S. (the U.S. Federal Funds Rate is currently 0.00% to 0.25%) and invest the funds in an emerging market such as India (where the RBI’s benchmark repo rate is 4%). The investor could convert the dollar loan to rupees and could invest in a relatively secure debt instrument in India that would fetch him a higher rate of interest.

For instance, an investor could borrow $1,000 in the U.S. at 0.25%, convert it into Indian rupees at Rs.73 to a dollar, and invest the resultant Rs.73,000 in a bond that offers 4%. A year later, his investment would yield him Rs.75,920. On redeeming his investment and assuming the rupee-dollar rate remains unchanged, the conversion into dollars should yield him about $1,040 (75,920/73). Thus, after repaying his U.S. loan with interest, or paying back $1002.50, he would be left with a gain of $37.50.

What is the biggest risk involved?

The main risk is the exchange rate risk.

If the conditions under which he borrowed funds to make his carry trade remained unchanged till he redeemed his investment and repaid his borrowing, he would be on velvet.

However, if for example, the rupee weakens against the dollar so much so that he now needs Rs. 75 to buy each dollar, then on conversion he would net only $1,012.27 (75,920/75). After paying back his U.S. loan, he would be left with a meagre gain of $9.77. Worse, if the rupee slides to Rs. 77 or Rs. 78 to a dollar, the investor will end up losing money!

How do carry trades impact a nation’s economy?

Any change in the global economic environment including actual changes or expectations of changes in interest rates in different markets could influence investors to pull their money out of a country and move it to another.

This in turn could cause a sudden outflow of the lower yield bearing currency, impacting the exchange rate of the country into which these funds were invested and thus potentially pushing up the cost of imports in that economy.

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