High yielding currency and Currency carry trade

High yielding currency and Currency carry trade

Subject: Economy

Section : External Sector 

Context:

Goldman Sachs Group has warned high-yielding currencies such as the Indian rupee and Indonesian rupiah may reel amid deteriorating external finances and as the Fed tightening spurs risk-off sentiment.

Concept:

High yielding currency-High-yielding currencies are those country’s currencies  where the rate is higher, thereby foreign investors earn quick profits.

Currency carry trade:

• Using the forex carry trade strategy, a trader aims to capture the benefits of risk-free profit making by using the difference in currency rates to make easy profits.
• In simple words, a currency carry trade is a strategy whereby a high-yielding currency funds the trade with a low-yielding currency.

The process:

• The first step in putting together a carry trade is to find out which currency offers a high yield and which one offers a low yield.
• A trader stands to make a profit of the difference in the interest rates of the two countries as long as the exchange rate between the currencies does not change.
• The funding currency is the currency that is exchanged in a currency carry trade transaction. A funding currency typically has a low interest rate. Investors borrow the funding currency and take short positions in the asset currency, which has a higher interest rate.
• As an example of a currency carry trade, assume that a trader notices that rates in Japan are 0.5 percent, while they are 4 percent in the United States. This means the trader expects to profit 3.5 percent, which is the difference between the two rates. The first step is to borrow yen and convert them into dollars. The second step is to invest those dollars into a security paying the U.S. rate.

Instances:

• The most popular carry trades have involved buying currency pairs like the Australian dollar/Japanese yen and New Zealand dollar/Japanese yen because the interest rate spreads of these currency pairs have been quite high.
• Historically, before the Lehman crisis, the USD-JPY carry trade was the most prominent trade where borrowing used to come from the Japanese market because of Bank of Japan’s accommodative monetary policy of low interest rate since the 1990s. The interest rate differential spread between the US and Japan prompted many traders to sell yen at low rates and buy dollars to earn the higher rates.
• Another instance where carry trade used to play out is in commodity-driven currencies. The Canadian dollar, which is very sensitive to oil prices and the yen, the low-yielding currency.
• Historically, falling commodity prices tend to eliminate yield differences between currencies. In such a scenario, reverse carry trades become profitable as oil prices fall and US interest rates start to rise. This will tend to push the currency exchange rates of the Canadian dollar lower.

Risk?

Inevitably, there are two risk factors involved in the forex carry trades, namely:

• The exchange rate risk- impacts a lot when there is a massive move in the exchange rate and this may lead to substantial loss in the base capital.
• The interest rate risk- it defines the profit yield of the carry trades positions, the wider the interest rate differential, the wider the opportunity.