Carry Trade Strategy
Table of Contents
EXECTIVE
SUMMARY:
In the current dynamic, diverse and
continuously changing environment the financing decisions of firms are also
changing. Firms generate funds across the border due to high benefits
associated from the international financing choices and stimulate the firms to
issue the bonds and equity in the international markets beyond the country’s
financial markets. The boundaries of the countries in terms of capital flow is
resolved now to ease the international operation of the firms.
Today many investors are interested
in “carry trade” strategy to gain the high returns on their investment. Carry Trade is mainly concerned with currency
operations and many people having view about carry trade as a type of gamble.
We are not sure about the returns from it due to uncertain future; however more
accurate information can lead to high returns. There is trade-off between the
benefits and costs of deregulations and many researchers view that Deregulation
of financial markets produces the favorable results while other scholars oppose
the idea and still favor to follow regulatory framework for effectiveness.
1. Evaluates the Impacts of Financial
Deregulation and Capital Control on Financial Globalization and International
Diversification:
The financing decisions of a
corporation depend upon various factors including strategic alignment with
their strategic goals and objectives and the financial markets and system of
the economy in which it is prevailing. Many studies are conducted on the bases
of domestic financial institutions whose operational scope are restricted to local
organization. Money market is use for short term loans and capital market is
used for long term loans. The people in the current time are not limited to the
local money and capital market, they are moving all over world to generate the
cheaply finance. Literature has evidenced various studies that support the
notation of financial decisions across the boundaries (Claessens, Djankov and
Nenova, 2001; Giannetti, 2003). They observe the deregulation of the capital
market and compare them with purely domestically financed firms. In 1970’s the
capital flow was at boom and the emerging markets gain benefits from this
change in the financial behavior of the capital market. This change was
triggered due to the oil shock in 1973-74. The growth of the euro bond market
and the bank lending was also at the peak 1979. Moreover, 2002 is usually
considered as the year of utmost transferring of funds from developed economies
to developing economies.
1.1Postive Aspects of Deregulation of
Financial Markets:
The integration of the financial
bodies across the boundaries has been increased tremendously. The barriers of
investing in the foreign markets have also been lifted up that enhance the
financial activity across boundaries. Many researchers suggest deregulation as
it reduces cost of capital, increase capital flow and lead to high growth. Ofstfeld
(1998) proposed that the international financial market provide effective and
profitable plate form for the investment. Stulz (1999) and Mishlin (2001) also argued
that the deregulation of financial markets provide more transparent and
accurate system of accountability and protect investors right. They further
argued that financial markets’ deregulation facilitate the international policy
makers and also lead to high economic growth. Financial innovations also allow
us to share the macroeconomic risks across the countries. With the opening of
international financial market, local firms can diversify their portfolio and
transfer their loss to their partner in the situation of loss. It broadens the
range of diversification by including the foreign bond and equity.
The mobility of the finance to the
other countries reduces the imbalances of external deficit. The developing
countries of the world mitigate the problem of scarcity of capital with the
financial innovation. This point is helpful to reduce the cost of capital and
play vital role in the economic growth of the country. Chari and Henry (2004)
take the observation of 430 firms from 8 different countries and concluded that
the appreciation in equity is 15 percent with the deregulation of financial
markets. Bekaert (2005) suggested that the financial market deregulation is
most favorable when the quality of the county’s institution and financial
development is high. So, he successfully describes the moderating effects of
quality of financial development with the relation of deregulation and its
benefits.
On the other hand some scholars also
argued against the system of deregulation. They opposed the system due to its
negative impacts in term of currency crises that also impact negatively to
whole financial system of that economy. They characterized the system of
deregulation to the financial crises in 1990’s. The Asian crisis was also due
to the support of this system. High capital flow is seen as fundamental cause
of such crises. However, other attributed these crises to flow of capital from
developing countries to developed economies. This point enforced the many
researchers to suggest the people to go back the older order of financial
decision. Stiglitz (1999) suggest that developing economies should put some
barriers in the free flow of funds to prevent themselves from its drastic
results. Rajan and Zingals (2001) argued that well established firms opposed
the economic reforms due to the possibility of intense competition. In some
countries general public also criticize this system, Soros (2002) and Stiglitz
(2002) also criticize the international capital flow widely. Gourinchas and
Jeanne (2006) the gain of developing countries from borrowing abroad for steady
capital stock is low as compare to their expectations.
In conclusion researchers are
unable to conclude the net benefits and losses of deregulations and view the
concept as trade-off between the costs and benefits of deregulations. The
researchers who are against this deregulation system proposed that most of the
crises are due to currency crises which is mainly due to the deregulation
system of the capital market. On the other hand, many people are in the favor
of this deregulation system due to the reduction in the cost of capital and so
many other benefits associated with it. Majority of studies and people are in
the favor of the financial deregulation and diversification of the countries.
2. Discusses the role of financial
innovations and technology on international investments:
High transaction cost and risks for
investor stimulates the change in financial markets and their operations. Today
financial innovative products and process along with technology are use to
cater the emerging needs of financial markets especially in the case
international capital markets due to its diverse and complex nature.
Financial innovation means to
introduce such methods that reduce the cost of the borrowings and minimize the risks
for investor. Financial innovation is one of the important factors that can
lead to high economic growth. During the last couple of centuries investors
have developed efficient systems of financing. Modern financer created the new
capital venture to monitor the high tech innovations and rearrange financial
data to support the biotechnology (Schweitzer, 2006). They further said that
financial intermediaries utilize their resources to evaluate the performances
of the firms. The innovative financiers are always in search of new and risky
projects for the sake of high returns while if they successfully develop the effective
innovative securities strategies they gain more than the follower
investors. According to Greenwood and
Jovanovic (1990) the financial intermediaries provide the more accurate and
authentic information to improve the allocation of capital due to technology
and innovative financial ideas. The statistical measurement of cost has
tremendously increases the efficiency of the portfolio. If we talk about the
technological changes then the changes in the structure of telecommunication,
information technology and financial theories change financial behavior of the
capital market. The role of data processing and telecommunication effects more
than the other related factors.
The technological changes in
financial activities especially in the banking sectors change the shape of
banking system. The online banking, ATMs and debt and credit cards all are very
effective. The role of the internet in the financial activities helps the
investors to remain aware about their stock price at anytime and anywhere in
the world. They can purchase and sell their securities online gain the profits
by the fluctuation in the prices of stocks. Moreover, symmetric information better
facilitate to predict and forecast accurately and help to manage portfolio
effectively.
The innovation in the financial
market is bringing through the agents who do not trade the securities directly
in the market instead of this they design the structure of the capital market.
They are in search of profit and participate actively in the formation of new
markets and traded them in the new market for the purpose of hedging. Their
main source of income through the sale of some specific securities rather than
based on the fees, they receive while performing their role of intermediaries.
Allen and Santomero (1997) shed the light on the issue that the importance of
the present financial innovation is due to the intermediary bodies who share
the risk of their agents, who feel risky to trade the securities directly. Some
agents are the international players; they have the knowledge of many stock
exchanges, by trading these securities internationally diversify the risk of
their principal.
The innovation of the new
securities allows the investors to gain the desirable return on their
investment. Dynan, Elmendorf and Sichel (2006) concluded that the financial
innovations can play an important role to manage income volatility. The key
role of finance in the economy and in its growth automatically enhances the
need of innovation in finance (Leivine 1997).
As we can say that finance is the major facilitator of all the other
activities therefore, the role of innovation in finance is very critical in the
development of economy. In many articles the role of importance in the
innovation of finance has been discussed (Van Horn, 1985; Miller, 1986:1992 and
Tufano, 2003). The stream of the innovation does not remain the same over the
period of time, for all type of firms and in every type of the environment. The
statistical risk measurement use to avoid and measure the other type of risk of
the rest of portfolio. Various types of the software and computer programmers
are used to forecast future sale and the performance of the firm. Berger (2003)
said that the technological changes enhance financial performance of the firm.
The profit percentage increases on the financial investment with the innovation
of derivative market. Mian and Sufi (2009) argued that securitization is one of
the very critical and important financial innovations of the recent time. There
are some direct channels through which the financial innovation can boost the
economic growth of the developing countries. They trade the risk of fluctuation
in income by trading the equity and derivatives with the foreign countries.
3. Analyze the Benefits and Risks of a
“Carry Trade” Strategy, in Which Investors Borrow Low Interest Rate. Interest Rate
Currencies to Finance Their Investments in Assets Denominated in Currencies
With Higher.
3.1 Carry Trade:
Carry trade strategy is use to take
the loans from low interest rate markets and invest them high interest rate
markets. This strategy involves of taking short position in low interest
currencies and long position in high interest currencies in a portfolio of
investment. Exchange rate of the currencies varies substantially and Investors
take benefits of such varying exchange rate. However, high risk is also
associated with this technique of gettinh benefits through interest differentials. The volume of the currency market is
increasing day by day. In the last 25
years it is observed that investing in the carry trade rather than the stock
market yields higher returns. The returns on these carry trade highly liquid
and connected with the foreign exchange market. Brunnermeier, Nagel, Pedersen
(2008) they argued that the participant of the levered market move towards the
high yield currencies due to the high interest of the speculators. If the local
currency depreciated the carry traders suffer losses if they taken the loan
from foreign countries. Forward biased
discount rate is not only the paramilitary condition of but it was compulsory
of carry trade. The logic behind this,
the commercial banks make the policy according to economic poison of their own
country rather than to focus on the external variables for policy making.
We can implement the strategy of
trade carry through different approaches and sources. The most and easy way to carry trade is
investing in the emerging markets and browed from the spot market. The targeted
currency can be hold in the form of short term financing until the maturity of
particular asset. Another important
approach to carry trade is based on the derivative contracts relies on futures
and options. We can follow any approach which is suitable for us based on the
complexity of the data. Galati and Malvin (2004) argued that large financial
institutions use the carry trade hedge funds and commodity trading advisors.
I f the speculators face the
problem of funding then the whole scenario will change. Brunneremeier and
Pedersen (2007) formulated a structure for speculators to carry trade at low
cost when the liquidity in the market is at the peak. A speculator only enters in the carry trade
if he believes or assumes that other speculators also join him.
The weights of carry trade are
considered stable and steady. The return on the carry trade is 4.65% higher
than the individual currency returns and the stander deviation is also lower.
This is the reason of the popularity of this strategy. Brunnermeier, Nagel and
Pedersen (2009) conclude that the rate of return on the carry trade is skewed
in the left side and fat-tailed while individual currency return is fate tail.
The result of carry trade totally
depends upon the speculation of currency rate. If your speculation clicks then
you gain the profit otherwise suffer the loss. We have to distinguish the high
and low risk environment and no chance of error at any cost. In the recession time of any economy the
systematic risk of the carry trade increases.
These findings guide us about the risk of carry trade which seems quite
attractive and profitable apparently.
Example:
Suppose that japans Yen exchange
rate with Australian dollar is 70 JPY per AUD. While interest rates in Japan
and Australia are 1% & and 5% respectively. While suppose that investment
yield in Australia is 10%. On the other hand UIRP suggests that in one year
japans yen will appreciate with 4%. Now we can gain from such interest and
currency differences. First borrow cheap Japans Yen at low rate and then
convert it into AUD. For instance you borrow 70 Yen at 1% and convert it into
AUD and get 1 AUD. Now invest that 1 AUD into Australian market and get 15%
yield after a year that return total amount of 1.1 AUD. Now convert this 1 AUD
into Yens. As UIRP suggest 4% appreciation in Yen as compared to AUD, so after
one year I AUD will be equal to 67.3 yens, so we will get 74.03 yen (1.1 *
67.3). Now return a total of 70.7 yens loan from Japan (70 yen loan + 0.7 yen
interest). Remaining 3.33 (74.03 – 70.7) is yours profit. But this hold true if
currency appreciate for only 4%. High appreciation in yens leads to low profits
while deprecation in yen as compared to AUD will lead to high profits.
4. Appraises the View That By Borrowing
in the International Capital Markets (e.g. Issuing Corporate Bond in
International Bond Markets or Cross-Listing its Equity in Foreign Stock
Markets) a Company can Generally Increase Its Share Price and Reduce its Cost
of Capital.
Globalization means that higher
flow of capital across the borders of the countries, close link with financial
markets. Another element relating to the globalization is the migration of the
security market at international level especially in the case of emerging
economies. When a company is listed in the foreign stock exchange, it has the
access to more liquid market, gains the fund at lower cost and at easy terms
and conditions. These developments and ease in financing is more charming for
the firms to be listed in abroad. Stulz (1999) proposed that moving abroad for
financial decision is risk and lower down the cost of capital. Shareholders
always want to diversify their portfolio internationally. Cantale (1996) and
Fuerst (1998) found that the firms listed in the foreign markets are willing to
commit the high stander of the corporate governance issues. Cleassens, Klingebiel and Schmukler (2002)
found that the increasing trend in the migration of stock at international
level is due to the no. of factors like, efficient legal system, excellent
macro policies, high per capita income and better protection to the shareholders.
There are many benefits of
international portfolio. According to Coffee (1999) and Rosee and Weisbach
(2002) conclude that when any firm issue the stock in which country having
strict rule of capital regulation and tight reporting system, they abide by
these situations. (Pagano, Roell and Zechner 2002) argued that if the foreign
markets are mole liquid, they take the full advantage of this high liquidity.
Ultimately reduces the cost of capital.
The international debt financing is more
common than the equity financing. For example in 1990,s 20.24% bonds are issued
internationally and equity is only 6% issued internationally. Usually U.K and
USA consider more attractive equity market for international operation.
European debt market is considered the most attractive in the world for the
foreign issuers.
The USA is considering the most
favorable place for the international equity issues, acquiring the 74% of the
cross boarder equity issues. We can say that on the bases of these results USA
equity market is largest in the world. UK is considering the second most
attractive cross-border equity issues, contributing 10% of international
equity. These two are the prominent foreign equity markets in the world. These
are exporter of the new equity.
The debt market is much more
international than equity market and the pattern of international debt issues
is more dispersed than the international equity market. The Eurobond market is more popular than USA
and UK fore foreign bond market.
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