Capital Markets Essay Example
The economic theory states that an investment strategy for exploiting interest rate differentials between currencies do not always turn into profitable returns (Bhansali, 2007). The investors who exploit this investment derive profits from differences in interest rates between the two currencies. The high interest rate currency depreciates in value against the low interest rate currency. Due to this depreciation, the investors who borrow currency with low interest rate to invest in one with higher interest rate realize that the return is worthless (Bhansali, 2007). The reason behind is that uncovered interest rate parity condition indicates that the expected return from the lending in the higher interest rate currency covers the borrowing costs of low interest rate currency. Nowadays, investors in financial markets who tend to exploit this mode of investment seem to be making profits from such strategies. Research and findings by scholars on the forward premium puzzle illustrates that the flow of exchange rates is a slow random exercise and gives advantages to investors who capitalise on the interest differentials and avoid suffering from exchange rate reduction (Ashraf, 2008).
Carry trade as a strategy in which an investor takes the advantage of interest rate differences to purchase currency with higher interest rate after selling currency with a relatively low interest rate normally affects the demand and supply of target currencies in foreign exchange markets (Ashraf, 2008). This causes loss of value of low interest rate currency and at the same time the appreciation of the high interest rate currency. The risk faced by investors, which drags the use of carry trades in many cases, is the expectations of change in foreign exchange rates. In supposition, carry trades in many instances do not give way to a conventional turnover because the variation in interest realisations should be equivalent to the investors’ expectations on the rise of the low-interest-rate against the high-interest-rate currency (Farhi and Gabaix, 2008). Further, carry trades fails to assist the investors achieve their target prevalence since they tend to sell all low currency investment to finance investments in higher value currencies. This is risky since it entails investment in one basket rather than maintaining a mix which mitigates against the effects of poor performance in one of the portfolios. Increase in interest rate attracts foreign capital thereby leading to immediate increase in value of the currency. Capital flows within the market makes the exchange rate to appreciate gradually, despite interruptions by depreciations.
In summary, the equity quality is characterised by individual investors’ tendency to purchase unlevered justness. Consequently, the alteration of uncovered interest rate parity using currency carry trades is principally based on professionalism and the willingness of investors to force up (Burnside, Eichenbaum, and Rebelo, 2007). When investors force up, conversely, they create a possibility of forced insolvency. (Burnside, Eichenbaum, & Rebelo, 2007). For this reason, a currency break down may compel investors to downsize their investments such that they do not succeed in enjoying the consequent returns of the carry returns (Belke and Polleit, 2009). Further, as concluded by the findings of various scholars, carry trade frequently acquire losses specifically when investors have problems with their funding (Belke and Polleit, 2009).
Ashraf, L., 2008. Currency Trading and Intermarket Analysis. New York: John Wiley and Sons.
Belke, A. and Polleit, T., 2009. Monetary Economics in Globalised Financial Market.London: Springer.
Bhansali, V., 2007. Volatility and the Carry Trade Journal of Fixed Income. New York: John Wiley and Sons.
Burnside, C., Eichenbaum, and Rebelo, 2007. Understanding the Forward
Consumption Growth Risk. Cambridge: Springer Press.
Farhi, E. & Gabaix, 2008. Rare Disasters and Exchange Rates.Massachusetts: National Bureau of Economic Research.
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