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Why carry trades cannot be ignored

Why carry trades cannot be ignored
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First Published: Tue, Mar 06 2007. 12 42 AM IST
Updated: Tue, Mar 06 2007. 12 42 AM IST
Mumbai: What began as a minor sell-off in the Chinese Stock Market has led to major turmoil in global markets.
Investors suddenly discovered an aversion to risky assets and, along with hedge funds, took a close look at their carry trades. Once, the carry trade phenomenon started to unwind, there was a bloodbath in the foreign exchange markets. The yen appreciated sharply and the “high yielders” dropped.
What are carry trades? Simply put, carry trade is a way investors take advantage of differentials in global interest rates, at the risk of currency fluctuations. They borrow in a low interest currency and invest in a high interest currency. Interest rates in Japanese yen are 0.5% a year, while the US dollar yields 5%. Hence, it would make sense to borrow in yen by paying 0.5%, convert the same to US dollar and invest it at 5%, thus capturing the carry (gain) of 4.5%. However, there is a catch. On maturity, the investor has to convert the US dollars back to yen to repay his loan. Now, as long as the yen depreciates, the investor has no problem as he requires fewer dollars to buy yen. The problem arises when the yen appreciates, which is exactly what happened.
With carry trades going haywire, investors developed cold feet on risky assets. They started shedding overseas assets, including those in India.
India still relies on overseas investors flows to fund its current account deficit (India’s trade deficit as on 8 January stood at about Rs24,992 crore). With oil prices continuing above $60 a barrel, the deficit is not expected to narrow sharply. Lack of capital flows may weaken the rupee against the dollar.?With the move just starting, The move has just started and it will possible take some time for the dust to settle.
Manis Thanawala and Subramanian Sharma are directors of Greenback Forex Services Pvt. Ltd
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First Published: Tue, Mar 06 2007. 12 42 AM IST
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