Global Finance PPT
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Transcript of Global Finance PPT
Carry Trade & Euro Credit Crisis
GLOBAL FINANCE TERM PAPER PRESENTATION
APARAJITA SINHA Roll No 622JONATHAN SYIEMLIEH Roll No 612
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
EXAMPLE
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
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
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
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%
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.
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)
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
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
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
Crosssection of skewness (Panel A) for different interest differentials i* - i
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
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
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
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!
Thank You!