Reasons behind Involvement in Carry Trade
With the rising level of competition, most investors are seeking alternative market gaps that would ensure they acquire loans at low interests. Carry trade is such a strategy used by investors in borrowing money at low rates to invest in an asset that would provide higher returns. However, the strategy is prevalent in foreign exchange market. For example, before 2007, most investors borrowed Japanese Yen and Swiss Francs to take advantage of low interest rates in Japan and Switzerland respectively (Christiansen, Ranaldo, and Soderlind 125). Likewise, the investors used the money in countries whose currencies are backed by higher interest rates like New Zealand and Australian Dollars, as well as the South African Rand. Even though most investors prefer such strategies, concerns have been on the rise due to the negative effects of carry trade on macroeconomic and financial stability; it contributes to extended periods in which the currency appreciates and finally declines.
According to the conditions set by the uncovered interest parity (UIP), interest rate differential between the domestic currency and riskless assets dominating the foreign market is often equal to the rate that the foreign currency should depreciate against the domestic currency. The major factor motivating most investors to engage in the carry trade is the fact that UIP appears to hold in the data. Historically, carry trades have been earning positive average returns in excess differentials between relevant currencies. The carry traders stand a chance of earning great profits as long as the exchange rates between the countries involved in trade remain the same. Moreover, the network enables individuals to question assumptions in the risk management process, avoid overreliance and belief on models, as well as impart skills to distinguish between predictable and unpredictable risks. For proper risk governance, individuals must interrogate the validity of the rules put forward for implementation; this eliminates instances of failure in managing risks.
Interest Rates in the Euro Zones
Just like some banks pay negative interests and charge the depositors to keep their money in the account, so do some central banks in Europe, which have cut the interest rates below zero. For some countries, the strategy aims at reinvigorating the economy after exhausting other options while some employ the method to push foreigners to move their money in other countries. Although some of the commercial banks began passing the negative rates to customers, it is crucial to note that such strategies might backfire.
The major factor that has been able to contribute to low interest rates in the euro zone is low expectation of inflation. Globally, economies are suffering from deficient demands. As a result, the real interests have been able to come down with reference to secular stagnation theory. Due to the recent gradual reduction of premiums to low levels, there has been a decline in the level of inflation expectation since the central banks showed commitment in ensuring stability of the economy. Additionally, the Euro zones experienced deterioration in the benefits associated with long-term growth indicating low levels of interest rates. Investors always incur losses since they tend to exhibit high purchasing power of the money within security period. However, the inflation premiums realized from long-term interest rates often aim at reimbursing the incurred losses (Clarida, Davis, and Pedersen 232).
The zone also experiences scarcity in safe assets, which plays an important role in reducing the interest rates. Whenever such incidents occur, the central government always ends up purchasing large amount of bonds, which in turn contributes to quantitative easing (QE). Most central banks in Europe greatly contributed to the declining interest rates when different states experienced global financial crises. While reinvigorating economic growth, these banks reduced interest rates virtually to zero for short-terms. Consequently, through QE, the long-term rates experienced direct downward pressure. Most investors perceive that government bonds are more valuable compared to the risks associated with other assets. With such shifts, the investors often elevate risk aversions that greatly contribute to the rising scarcity of the bonds. Moreover, the investors could also move to government bonds when European countries experienced reduction net issuance that could contribute to reduction of the banks’ yields to zero. Most European countries are currently enacting new regulations of enhancing financial stability. However, such regulations are constraining various financial institutions like the insurance companies, banks, and pension funds. As a result, these institutions are holding the debts of the government. When the interest rates hit zero, few options would be available for the Euro Zones to remedy the situation.
Target Currencies in the Euro Carry Trades
Carry trades are more prevalent in areas experiencing decline in interest rates and future benefits from such investments. Euro offers such benefits making it acquire better position in funding carry trade. Markedly, pairing the Australian currency and euro (EURAUD) offers the pair for the trade. The Australian dollar is stable and generates relatively high yield making it the target currency in the carry trade. It is important to note that carry trade encompasses purchasing high yielding currencies with another currency that has low cost. Factors such as low inflation and deflation play important role in keeping the interest rates low within short period. These factors have made Japan dominate the trade for many years (Woodfield and Blackwell Global Investments Limited par. 7).
Taking precautionary measure to address the prevailing condition is important. Japan focusses on encouraging inflation to stabilize interest rates. Through such measures, long-term carry trades could experience potential losses due to increased costs of the assets. Notably, the investors could experience greater losses if Japan’s currency (yen) strengthens. On the contrary, using euro in combating deflation might lead to further devaluation and stimulus of the currency. As a result, the traders would benefit more from the yield generated from carry trade as well as paying back their loans at considerably cheaper cost (Valenski 135). Traditionally, high yields in Australia have been the major factor attracting investors who are after greater returns. Besides, the country experiences stable political regime that has greatly contributed to the confidence of the investors. Currently, the Australian interest rate stands at 2.50%, which makes a differential on the EURAD trade at 2.40% yield. The uncertainty perspective approach is the most preferable approach in the risk identification segment given that it does not only determine all possible sources of threats, but also determines all possible sources of positive risks or opportunities. With increasing changes in the banking industry, there are always unrelenting follow-ups and frequent updating of the identification lists as per the knowledge and comprehension of the business atmosphere. Risk assessment helps firms to group risks according to their severity. The process helps financial strategists to prioritise risks as per their occurrence probability, as well as address uncertainty through effective decision-making.
Change of Positions by the Carry Trade Investors
There are several benefits associated with carry trade. However, it is important to note, especially for investors, that there are several risks associated with the practice as well. The aim of every investor is to make profit. All the transactions carried out in the trade are conducted with much leverage; therefore, a smaller change in the exchange rates could lead to losses unless investors hedge their positions properly (Hattori and Shin 272). Most investors often stick with the carry trade only if it exhibits the positive nature, which occurs when the investors borrow an asset at considerably lower interest rates to finance their investment in a different asset that has higher returns. On the contrary, most investors often change their positions upon realizing that their activities are reflecting a negative carry trade. The negative nature occurs whenever the yield of holding an asset is not enough to cover the financing cost. As a result, such instances always make investors lose more profits. The best potential carry trades always occur where there is a greater interest rate differential occurring between two competing currencies.
To realize the overall profitability, investors tend to position themselves in a manner that their assets maintain value over time. Essentially, most carry trades work best whenever there is risk appetite in the market. Therefore, the riskier currencies should be in demand to allow selling of less risky currencies like the Yen. Such factors would help investors stay in the trade for a long time while increasing the profitability of the interest rates. Alfaro and Kanczuk (125) observe that countries presented with riskier currencies are in risk-aversion mode, reflecting the ideal market conditions for most investors. Most investors are also leaving trade due to the increasing popularity of the larger institutions making carry trade very overcrowded. Most traders also fear problems associated with inconsistent profits.
Alfaro, Laura, and Fabio Kanczuk. Carry Trade, Reserve Accumulation, and Exchange-Rate Regimes. Cambridge: National Bureau of Economic Research, 2013. Print.
Christiansen, Charlotte, Angelo Ranaldo, and Paul Soderlind. The Time-Varying Systematic Risk of Carry Trade Strategies. London: Centre for Economic Policy Research, 2009. Print.
Clarida, Richard, Josh Davis, and Niels Pedersen. Currency Carry Trade Regimes: Beyond the Fama Regression. Cambridge: National Bureau of Economic Research, 2009. Print.
Hattori, Masazumi, and Hyun Shin. The Broad Yen Carry Trade. Tokyo: Institute for Monetary and Economic Studies, 2007. Print.
Valenski, Ed. “Fumbling the ”Carry Trade”.” The Wall Street Journal 15.7 (2015): 128-152. Web. 25 Oct. 2015.
Woodfield, Ross, and Blackwell Global Investments Limited. EURAUD: The New Carry Trade. 2014. Web.