Question

1.Why are interest rates so low in the traditional core markets of USD and EUR?

2.What makes this “emerging market carry trade” so different from traditional forms of uncovered interest arbitrage?

3.Why are many investors shorting the dollar and the euro?

Answer 1

1)

Following the global financial crisis in 2008-2009, central banks in both the United States (the U.S. Federal Reserve) and Europe (European Central Bank) have kept interest rates extremely low to provide liquidity in the system, sustain commercial banks which are in or near-crisis in terms of capital, and provide as much monetary stimulus to the economies as possible.

The desired goal of these strategies was to provide cheap liquidity for instances for banks, which were expected to forward a decent part of this liquidity to the economies through credits or investments -> low-cost funds

2)

During that time, Japan becomes one of the emerging markets; therefore, the emphasis has been on Japan because of the high investment funds rate in Japan. The subsequent factor is the well-developed financial sector. Yen is additionally viewed as the most universal of every single Asian currency.

The carry trade has long been associated with Japan and the relatively low-interest rates which its financial community has made available to multinational investors.

A form of uncovered interest rate arbitrage (UIA), the Japanese carry trade was based on an investor raising funds in Japan at low-interest rates and then exchanging the proceeds for a foreign currency in which the interest rates promised higher relative returns.

Then, at the end of the term, the investor could potentially exchange the foreign currency returns, plus interest, back to Japanese yen to settle the obligation and also, hopefully, a profit.

The entire risk-return profile of the strategy, however, was based on the exchange rate at the end of the period being relatively unchanged from the initial spot rate.

3)

The US and the Eurozone currently have very low-interest rates and high debts. As it is possible to borrow cheaply in EUR or USD and to invest in other currencies at more favourable interest rates, many investors short the EUR or USD and buy e.g. currencies of emerging markets, which show strong economic growth and decent inflation. Thus, these currencies are expected to strengthen, which will cause a weaker EUR or USD and better exchange rates when changing the emerging market currencies back into EUR or USD. Through this, high profit is realized.