Rising interest rates come as sad news for those who wish to take a home loan or a car loan.
However, rising interest rates bring several opportunities with them as well…
And one opportunity in this regard is that of ‘Carry Trade,’ which means borrowing in one market where interest rates are lower and investing in another market where interest rates are high and thereby making a gain.
But it is not that simple because it involves two different currencies. One currency is of the country where interest rates are low while the other currency is of the country where interest rates are high.
For example…
For ‘Carry Trade’ to be profitable, it is crucial that the exchange rates between the countries remain stable. Otherwise instead of a gain one could end up making a serious loss. Thus ‘Carry Trade’ is not devoid of risk.
How are ADRs priced?
Now, as we always do, let us try and get a better understanding of the concept with the help of an example.
Let us assume that the interest rate in US is 2% whereas is in India it is 7% And let us say someone borrows $100 in USA to invest in India at 7%.
It is evident that the differential of 5% (7% – 2%) is the opportunity to make a profit by taking an exchange rate risk.
Let us assume the exchange rate is Rs.80/- = $1.
Now if someone in the US wants to invest in India, he must invest Indian Rupees for which he has to purchase Indian Rupees.
So, if the amount in question is $100, then as per assumed exchange rate of Rs.80/-, it would amount to Rs.8000/-.
So, when Rs.8000/- is invested for one year in India at 7%, it would earn an interest of Rs 7% x 8000 = Rs.560/-.
Thus, at the end of the period the total amount would be Rs.8560/-.
On conversion assuming no change in exchange rate, it would be $ 8560/80 = $107 or net earnings of $7.
Now had the investment been made in the USA itself at 2%, it would have earned net $2 only.
Hence by participating in carry trade an additional $5 profit opportunity emerged because of differential interest rates between two countries.
But here we have made a huge assumption that the exchange rate remained stable across the investment time period.
This, however, may not be the case most of the time & in the event of exchange rate variation, the consequence can be painful for the investor.
Let us see this by looking at the same example.
We had assumed the exchange rate as Rs.80/- = $1
At 7% we saw that the investor in our example made Rs.560/- and the final amount that he received was Rs.8560/-. At the exchange rate of Rs.80/- = $1 he received $107.
However, if the rupee grew weaker in the interim period to Rs.90/- = $1, he would now receive only $ 8560/90 = $95.11.
Thus, he would make a loss of nearly $6 instead of a gain of $2 he would have made had he invested in USA itself.
This is
the currency risk that one must take in carry trade. If the currency of investment becomes weaker the consequences for the investor are painful and if the currency on the other hand were to get stronger its gains too would get stronger.
Conversely, if the exchange rate had become Rs.70/- = $1, he would have made USD 8560*/70$ =$122.29 which would have given him a significant gain of $22.29 vs. $2 if he had invested in USA itself.
Since ‘Carry Trade’ involves borrowing in one market to fund investments in another market,
both ‘gains’ and ‘losses can get magnified due to the currency fluctuations.
However, in real life, the moment the traders get a feel that exchange rates are changing unfavorably, they rapidly unwind their positions by withdrawing their investments, and converting them into dollars.
This is famously known as ‘Carry Trade Unwinding.’
While I have explained ‘Carry Trade’ in fixed income investment in my example, one must understand that ‘Carry Trade’ also refers to investments in any other asset class like shares, commodity, real estate, etc. in one country by taking leverage from another country.
