INTERNATIONAL CORPORATE FINANCE PROF. P.C.

BISWAL

PROJECT REPORT
Relationship between Interest Rate Differentials and Exchange Rate Movements Implications on Exchange rate Movement and Hedge Funds Trading
Section A: Rahul Agarwal (10P040), Kriti Jain (10P085), Shalabh Arora (10P109) Shishir Srivastava (10P111)

TABLE OF CONTENTS
Table of Contents....................................................................................................... 2 Uncovered Interest Parity & Covered Interest parity...............................................3 Carry Forward trade................................................................................................4 Factors Affecting Carry trade...............................................................................5 Risks of Carry Trade Strategy Leverage and Unwinding....................................6 Examples of Carry Forward Trade........................................................................9 Hedging Carry Forward Trade...............................................................................11

UNCOVERED INTEREST PARITY & COVERED INTEREST PARITY

Uncovered Interest parity is said to exist between two currencies when the exchange rate moves in such a manner that it offsets any gains that can be made from the strategy of borrowing a currency with low interest rate and investing in a currency with high interest rate. For e.g. If the interest rate on Japanese Yen is equal to 1% and that on Australian Dollar is 8%, one can borrow Japanese Yen and invest in Australian Dollar. However, under the existence of Uncovered Interest Parity condition, Japanese Yen will

appreciate against the dollar by about 7% so that an opportunity for arbitrage does not exist. For covered interest parity to exist, the forward rate of the two currencies shall also be such that a condition of arbitrage is nonexistent. i.e. Japanese Yen will be at a forward premium in the above example while Australian Dollar will be at a forward discount so that no gains can be made. Historically it has been observed that the exchange rate movement cannot be explained by Uncovered Interest Rate parity. In fact, statistically there is more proof against this theory. In a majority of cases, the currency with high interest rate appreciates thereby providing double benefits to investors who invest using this strategy. This strategy of exploiting the absence of uncovered interest rate parity is known as carry forward trade. A vast

number of hedge funds employ this strategy and make major gains through it. We shall see in the ensuing sections some historical proofs of this carry forward trading. We shall also see how carry forward trade has impacted exchange rate movement and also some carry forward trade opportunities currently existent in the forex market.

CARRY FORWARD TRADE As mentioned earlier borrowing in a currency with low interest rate and lending in a currency with high interest rate, is a strategy referred to as carry trade. Currencies which have a low interest rate are at a forward premium. Carry Forward trade can also be executed by going short in currencies with a forward premium and going long in currencies which offer a forward discount. Figure 1 summarizes the two ways of execution of the carry forward trade strategy. An example of Carry Forward trade is as follows: Interest Rates : US Dollar : 5.25%,JPY : 0.25 % Exchange Rate : 119.10, 10M = $83,963 Borrow in lower interest rate currency and invest in higher return currency One year later : $83,963*1.0525=$88,371 Repaying the debt @ 115.00

$88,371*115.00/$=10,162,665.00

Profit : 10,162,665.00-10,000,000.00*1.0025=137,665 (or ~$1200) Carry Forward trade has been in wide use by hedge funds worldwide and significant examples exist of such kind of trade.

FIGURE 1

FACTORS AFFECTING CARRY TRADE Following factors also determine the extent of carry forward trade prevalent in the forex market. These are:

Choosing the weights of the portfolio in order to maximize its Sharpe ratio. Investors invest in currency pairs where the return is maximum per unit of risk. Portfolios of currency pairs are constructed on the basis of the minimization of risk or maximization of Sharpe ratio.

Transaction costs, such as bid-ask spreads, lower average payoff and hence have a negative impact on the gains that can be made by Carry Forward Trading Strategy

Changes in supply and demand for currencies involved - Selling short funding currencies and, at the same time, buying target currencies can be influenced on a short term by the demand and supply of currencies which impact the prevalent spot rate

Depreciation

of

low-interest-rate

funding

currencies

and

the

appreciation of high- interest-rate target currencies. This can minimize gains made by carry forward trading. In some instances a sharp appreciation of a low interest rate currency can even lead to

RISKS OF CARRY TRADE STRATEGY LEVERAGE AND UNWINDING We shall now talk about some of the risks associated with Carry trade Strategy:Figure 2 summarizes these risks

FIGURE 2

Currency Risk If the exchange rate moves such that any gains made through carry forward trade are negated by the movement of exchange rate then the investor stands a risk of not only having lesser gains but he may also lose some money because of the exchange rate movement. Leverage Risk With higher leverage existing in todays market conditions, a small swing in exchange rate movement can lead to sharp losses in forex market.
LEVERAGE

Leverage: It is the ability to control a large amount of money using none or very little of your own money and borrowing the rest For example, in forex, you can control $100,000 with a $1,000 deposit. Here leverage is 100:1 & margin is the $1,000 deposit. It is a risky instrument for investors as the downside during rough times is equivalent to the upside during good times.

`
AU /U D D S Interest ra inAus lia te tra Interest ra inU te nitedS tes ta Interest R teD a ifferentia l

20 07
0 4 .8 6 5 .2 % 5 5 .2 % 1 0 .0 %

20 08
0.84

20 09
0.78

21 00
0 2 .9 3 5 .7 % 0 5 .2 % 3 0 .5 %

21 01
0 8 .9 4 5 .7 % 0 5 .2 % 4 0 .5 %

FIGURE 3

Figure 3: Popular leverages used by the brokers.

2 0 .5 %

6 5 .7 % 4 5 .2 %

4 5 .2 % 2 % 2 5 .2 %

An example of how leverage impacts the gains made through carry trade is shown below S teg : G tra y oinglonginAU /U D D S
100 00 4 5 .2 % 6 5 .2 % $ 0 .0 20 0 -$ .8 9 0 $ 9 .2 10 0 1 9 .5 % 7 6 .9 % 100 00 4 5 .2 % 6 5 .7 % $ 5 .0 20 0 -$ 5 .0 51 6 -$ 0 .0 31 6 -2 2 .5 % -1 .5 % 2 8 100 00 1 0 .5 % 4 5 .2 % $ 7 .0 25 0 $ ,3 4 6 1 6 .8 $ ,6 9 6 1 3 .8 1 .8 % 2 1 6 .0 % 4 3 100 00 0 5 .2 % 3 5 .7 % $ 5 .0 30 0 $ 9 .2 58 9 $ 4 .2 98 9 8 0 .7 % 4 .5 % 3 0

T d S e ra e iz B orrowR te a L endR te a Interest E rned a Profit/L d to c ng inAU /U D oss ue ha e D S T l return ota Y ield R eturnif lev g is5 era e :1

FIGURE 4

Figure 4 is an example of such strategy and gives the total return and yield with the strategy of going long in the AUD/USD pair. The yield with a leverage of 5:1 is shown in the last row and is illustrated in Figure 6.

FIGURE 5

FIGURE 6

Interest Rate Shift Risk Although most Central banks fix the interest rate based on long term monetary policy however, there have been instances where an interest rate change has rendered the carry forward trades

unprofitable. For example US Dollar/ Japanese yen was a historical favorite for Carry Forward Trades. However, after the Great Recession, the interest rate on US Dollar has dropped rapidly leading to unwinding of Carry forward trades in this currency pair. Unwinding of carry forward can lead to a sharp appreciation of currency with low interest rate so that all gains made by carry forward strategy are eliminated.

EXAMPLES OF CARRY FORWARD TRADE

In this section we talk about some historical examples where a rise in forex trade has been ascribed to carry forward trade.

FIGURE 7

Figure 7 illustrates the exchange rate movement, interest rate differential and forex turnover from 1998 to 2004 between US dollar and Australian

dollar. It is observed that as the interest rate differential has increased between USD and Australian Dollar, the forex turnover has increased and has doubled from 1998 levels. Moreover, the Australian dollar has actually appreciated against he Us dollar in the same period. This implies that anybody using the carry forward trading strategy would have gained both from the interest rate differential as well as the exchange rate movement. The 2001-2004 BIS Triennial report cites this particular example where a rise in forex trading can be attributed to the use of carry forward trading strategy by hedge funds. There are other instances as well where Carry Forward Trade has been used to describe a surge in forex trading between currencies. The 2004-2007 BIS Triennial Report mentions such instances where an unwinding of carry trade positions lead to an appreciation of a low interest rate currency. Following are some excerpts from the 2004-07 BIS triennial report. Rise in FX volatility and increased risk aversion of investors led to rapid unwinding of currency carry trade positions Funding currencies were appreciating sharply and many investors experiencing large losses. Japanese yen, for example, appreciated Australian dollar on 16 August 2008 by 7.7% against the

Another illustration which point to the unwinding of carry forward trade is as shown below. Figure 8 shows the unwinding of carry trade in the New Zealand Dollar and Japanese Yen currency Pair form August 2007 onwards.

FIGURE 8

Hence, we can see the extent to which the carry forward trade strategy is used by hedge funds and the kind of impact it has on the forex turnover as well as the exchange rate movement

HEDGING CARRY FORWARD TRADE In this section we shall talk about a strategy of hedging carry forward trade and identify currency pairs which can be invested in with the use of such a strategy

We hedge one long carry trade with another short carry trade using different currency pairs that are closely correlated and which results in a net interest rate benefit to the overall position For example, a hedged carry trader might exploit interest rate differentials between well correlated currency pairs like the following: EUR/USD and USD /CHF AUD/USD and NZD/USD GBP/USD and USD/CHF Such hedged carry forward trades are highly leveraged. However, they carry a risk if the correlation between currencies breaks down. The steps involved in executing such a strategy are as follows:-

20 07
Cn d aaa A s lia u tra Y ield 4 5 .2 % 6 5 .2 % 2 0 .0 %

20 08
4 5 .2 % 6 5 .7 % 2 0 .5 %

20 09
1 0 .5 % 4 5 .2 % 2 5 .7 %

21 00
0 5 .2 % 3 5 .7 % 3 0 .5 %

21 01
1 % 4 5 .7 % 3 5 .7 %

FIGURE 9
1.066000 1.141100 1.030200 U D A we shall try to execute such 0 strategy. Figure 10 illustrates .0 2 5 such S /C 1 780 .0 3 a 1 one 004 Next D

AD S U /U D

0 300 .8 7 3

0.836050

0.780945

0 141 .9 7 3

0 720 .9 7 6

hedged carry forward trade and the corresponding returns

T d Se ra e iz B orrowR te a L n R te ed a In teres E rn d t a e Profit/L s d etoc a g inA D S os u hne U /U D Profit/L s d etoc a g inU D A os u hne S /C D F a R tu in l e rn Y ield R rnif L v g is5 etu e era e :1 $ $ $ $ 100 00 4 5 .2 % 6 5 .2 % 20 0 0 .0 (9 0 .8 ) (7 .0 ) 8 0 12 0 1 .2 0 9 .5 % 2 4 .9 % $ 100 00 4 5 .2 % 6 5 .7 % 20 0 5 .0 $ 100 00 1 0 .5 % 4 5 .2 % 25 0 7 .0 $

S te y L ginA D S a ds ort inU D A tra g : on U /U D n h S /C D 100 00 0 5 .2 % 3 5 .7 % 30 0 5 .0

$ (5 1 6 5 .0 ) $ 71 0 5 .0 $ 49 4 4 .9 2 7 .3 % 1 .8 % 1 3

$ 1 6 .8 ,3 4 6 $ (1 0 .0 ) ,1 9 0 $ 50 6 3 .8 2 6 .7 % 1 .8 % 3 1

$ 58 9 9 .2 $ (2 1 6 8 .4 ) $ 66 3 6 .8 3 2 .4 % 1 .1 % 7 2

FIGURE 10

FIGURE 11

Identification of currencies can be done by identifying currencies with high correlation. Figure 11 recognizes such currency pairs (highlighted in blue).

Figure 12 summarizes the investment strategy based on the above table N o. Long Short Interest Rate Diff Decision Invest as Australia and Canada are both stable countries

1 AUD/USD

USD/CAD

3.75%

2 USD/BRL

USD/AUD

9.75%

Risk seekers can invest but need to take Brazils country risk into consideration

3 AUD/USD 4 BRL/USD

USD/NZD USD/CAD

2.25% 10%

Least return among other options hence avoid Risk seekers can invest Switzerland and Singapore both are developed countries

5 CHF/USD
FIGURE 12

USD/SGD

4%

Such a hedged carry forward trade minimizes the risk associated with exchange rate movement while yielding above average market returns.