Exchange rate, interest rate and

carry trade
Presented by:
Amith kumar
Harsha N M
Manasa S S
Interest Rate

What is interest rate?
An interest rate is the rate at
which interest is paid by a borrower (debtor)
for the use of money that they borrow from
a lender (creditor). Specifically, the interest
rate is a percentage of principal paid a certain
number of times per period.
Role of Interest Rate
Interest-rates are a vital tool of monetary
policy and are taken into account when
dealing with variables
like investment, inflation, and unemployment.
The central banks of countries generally tend
to reduce interest rates when they wish to
increase investment and consumption in the
country's economy.
Reasons for interest rate fluctuations
Political short-term gain.
Deferred consumption.
Inflationary expectations.
Alternative investments.
Risks of investment.
Liquidity preference.
Taxes.
Tools to control interest rate risk.

Step 1
Match maturities of borrowings and maturities of
loans
Step 2
Invest in securities with maturities shorter than
two years
Step 3
Use derivatives and interest rate swaps to hedge
the interest rate risk.
Continue..
Step 4
Buy floating rate investments if you do not
have enough money to qualify for professional
cash management
Step 5
Pay off revolving lines of credit monthly.
The relationship between exchange
rates, interest rates
Interest rates are the return to holding
interest-bearing financial assets. In the
previous lecture we have pointed out that as
being a financial asset exchange rates tend to
adjust more quickly to new information that
goods prices. Like exchange rates, interest
rates are also the prices of financial assets and
hence adjust quickly to new information.

The profit seeking arbitrage activity will bring
about an interest parity relationship between
interest rate of two countries and exchange
rate between these countries.



Exchange Rates
Nominal exchange rate: price of one currency in terms of
another currency (bilateral exchange rate)
example: 1.36 dollars per euro or 0.74 euros per dollar
determines price of imports
foreign exchange market

Nominal effective exchange rate: average nominal
exchange over several other important trade-related
currencies

Nominal Exchange Rates
Real Exchange Rate (RER): the price of domestic
goods relative to foreign goods
says how much foreign good you could get for
domestic good
The price of the average domestic good or service
relative to the price of the average foreign good or
service, when the prices are expressed in terms of a
common currency

Real Exchange Rates
Advantages
Reduced risk in international trade
Introduces discipline in economic management
Fixed rates should eliminate destabilizing speculation
Disadvantages
No automatic balance of payments adjustment
Large holdings of foreign exchange reserves required
Loss of freedom in your internal policy
Fixed rates are inherently unstable
Nominal Exchange Rate
RER Example
Should you buy a Japanese or American computer for your
company?
Price of U.S. computer = $2,500
Price of Japanese computer = 242,000 yen
Exchange rate = 102.18 yen/dollar
Price in dollars = price in yen/yen-dollar exchange rate
Price in yen = price in dollars x value of dollar in terms
of yen
Price in dollars = 242,000 yen/110 = $2,368.36
Japanese computer is cheaper.
Real exchange rate = $2,500/$2,368.69 = 1.05

Exchange Rates
Advantages
Automatic balance of payments adjustment
Freeing internal policy
Absence of crises
Flexibility
Lower foreign exchange reserves
Disadvantages
Uncertainty
Lack of investment
Speculation
Lack of discipline in economic management
Inflation
Real Exchange Rate
Currency carry trade
A strategy in which an investor sells a certain
currency with a relatively low interest rate and
uses the funds to purchase a different
currency yielding a higher interest rate. A
trader using this strategy attempts to capture
the difference between the rates, which can
often be substantial, depending on the
amount of leverage used.

Example
Carry trades are common instruments in the currency
markets. One of the most popular carry trades have
been to borrow money in Japan and use it to invest in
other countries. This has been fueled by a low
Japanese interest rate. For example: An investor could
borrow money at Japan at 2% interest and invest it in
US treasuries at 3% interest -- allowing the investor to
keep the excess 1%.
Currency carry trades bear the risk of changing
exchange rates. In the example above, the investor
could potentially lose money if the US dollar fell in
value against the Japanese Yen.

How is Carry Trade Done?

The theory of uncovered interest rate parity suggests
that carry trades should not yield predictable profit.
The argument behind this is that the interest rate
difference between two countries should equal the
rate at which the investors expect the low interest rate
currency to rise against the high interest rate currency.
However, it is notable that foreign exchange rates may
change in such a manner that the investor is compelled
to pay back a more expensive currency. Since investors
tend to sell the borrowed currency to convert it to
other currencies, it may weaken the borrowed
currency.

Benefits of Carry Trade
Carry trade is an important strategy of
investment for profiting at times of global
financial stability.
Carry trade belongs to the currency trading
market, which is one of the most developed
markets of the world
The perennial problems faced by a trader
relate to the achievement of consistency in
profits, and the minimization of losses.
Risks of Carry Trade

The main risk associated with carry rate is that
it depends upon the uncertainty of exchange
rates. Another risk involved is that carry trade
is undertaken with a high level of leverage. In
such cases, huge losses could be suffered even
with a small movement in the exchange rates.
This can be prevented only through
appropriate hedging.

conclusion
We may conclude by noting that in spite of all the
arguments against it, the carry trade remains a
valid and highly profitable trading strategy for
many different kinds of traders. If you seek to
apply this approach in your trading decisions, we
recommend that you choose a suitable one
among the forex brokers

that offer a high interest
income for pairs held. There is a great degree of
variability in the carry friendliness of brokers, and
youd do well to research this aspect thoroughly
in order to maximize your returns.