What is Currency Carry Trade? How Federal Reserve & Indian Markets are Co-related? What are the impacts of increased interest rates on India? What are the risks associated with Currency carry trade? Read here to know about Currency Carry Trade.
The US Federal Reserve, the US central bank, recently hinted at potential interest rate increases. Indian markets have reacted nervously as a result of this.
In addition to having an impact on the US economy, the Federal Reserve’s rate increases also have an impact on the macroeconomic outlook and to a lesser extent, the monetary policies of other rising nations.
What is Currency Carry Trade?
A currency carry trade is a strategy in which a trade is funded with a high-yielding currency and a low-yielding currency. Depending on the degree of leverage applied, a trader utilising this method tries to profit from the difference between the rates, which is frequently rather large.
One of the most used trading techniques in the forex market is the carry trade. It’s because these currency pairs have had rather wide interest rate spreads. Finding out which currency offers a high yield and which one offers a low yield is the first stage in putting together a carry trade.
A trader who employs the forex carry trade strategy seeks to gain from the advantages of risk-free profit-making by taking advantage of the difference in exchange rates to generate quick profits.
Mechanics of the Currency Carry Trade
- Finding out which currency offers a high yield and which one offers a low yield is the first stage in putting together a carry trade.
- As long as the exchange rate between the two currencies remains constant, a trader can profit on the differential in interest rates between the two nations.
- In a currency carry trade transaction, the currency that is exchanged is known as the funding currency. Usually, a funding currency has a low interest rate. In order to trade short in the asset currency, which has a higher interest rate, investors borrow the financing currency.
- Consider a trader who notes that rates in Japan are 0.5 per cent while they are 4 percent in the United States as an example of a currency carry trade. This indicates that the trader anticipates making a profit of 3.5%, or the difference between the two rates. Borrowing yen and converting them to dollars is the first step. The next step is to invest those funds in a security paying interest at the US rate.
How Federal Reserve & Indian Markets are co-related?
- In comparison to developed nations like the US and many (mainly Western) European countries, emerging economies like India typically have greater inflation and interest rates.
- Financial institutions would therefore choose to borrow money in the US at low interest rates in dollar terms and then invest that money in government bonds of emerging nations like India in local currency to earn a greater rate of return.
- The gap between the interest rates of the two nations narrows when the US Federal Reserve increases its domestic interest rates.
- As a result, India becomes less desirable for currency carry trade, and some money may be anticipated to leave Indian markets and return to the US.
- A currency carry trade is a strategy in which a trade is funded with a high-yielding currency and a low-yielding currency.
- Consequently, the value of the Indian rupee relative to the US dollar declines.
Also read: Internationalisation of Rupee
What are the impacts of increased interest rates on India?
On Equity Market:
- Due to the increasing dollar shortage on the global market, bond rates will increase.
- The strengthening of the dollar and the uncertainties caused by the trade war between the US, China, the European Union, and other major countries had caused outflows of about Rs 40,000 crore rupees from India’s debt and equities markets.
On Export and Forex:
- India is one of the biggest importers of crude oil worldwide.
- Crude oil imports become more expensive when the rupee depreciates against the dollar, which may cause cost-driven inflation to spread throughout the entire economy, particularly in sectors that are particularly vulnerable to changes in the price of crude oil.
- On the other hand, India’s exports, particularly those related to IT and IT-enabled services, may somewhat gain from a stronger dollar relative to the rupee.
- Due to intense rivalry in the export industry, exporters might not completely benefit from the same thing.
What are the risks associated with Currency carry trade?
Inevitably, there are two risk factors involved in the forex carry trades, namely:
1. The exchange rate risk
- It impacts a lot when there is a massive move in the exchange rate and this may lead to a substantial loss in the base capital.
2. The interest rate risk
- It defines the profit yield of the carry trades positions, the wider the interest rate differential, the wider the opportunity.
Article written by: Aseem Muhammed