Theoretical Background and Simulation of the Carry Trade Strategy within CEE-States

Bachelor Thesis 2011 43 Pages

Business economics - Banking, Stock Exchanges, Insurance, Accounting


Table of Contents

List of Appendices

List of Figures

List of Tables

List of Formulas

List of Abbreviations

1 Problem outline and significance
1.1 Purpose and Motivation
1.2 Research question
1.2 Methodology
1.3 Disposition
1.4 Terminology

2 Foreign Exchange Markets
2.1 Characteristics of the Foreign Exchange Market
2.2 Efficient Market Hypotheses

3 International Parity Relationships
3.1 Parities
3.2 Interest Rate Parity
3.3 Purchasing Power Parity
3.4 Unbiased Forward Rate
3.5 Fisher Effect
3.6 International Fisher Effect

4 Carry Trade Strategy
4.1 Forward Premium Puzzle
4.2 Explanation of the Carry Trade Strategy
4.3 Risk and Profitability of the Carry Trade Strategy

5 Data set and explanation of the case study
5.1 Assumptions
5.2 Foreign Exchange Rate
5.3 Money Market Rate
5.4 Spread Sheet for Carry Trade Strategy and its Results

6 Fundamental law of Active Management
6.1 Active Return
6.2 Active Risk
6.3 Information Ratio

7 Conclusion and critical acclaim



List of Appendices

Appendix 1: The circadian Rhythms of the FX Market

Appendix 2: Monthly long and short positions

List of Figures

Figure 1: Structure of the paper

Figure 2: Currency distribution of global foreign exchange market turnover (Percentage shares of average daily turnover in April 2010)

Figure 3: Three categories of EMH

Figure 4: The International Parity Relationships,,

Figure 5: Development of the foreign exchange rates

Figure 6: Annual volatilities of the exchange rate

Figure 7: Development of the money market rates

Figure 8: Annual volatilities of the money market rates

Figure 9: Calculation of the profit or loss on a short position

Figure 10: Monthly profit and loss development [in USD]

Figure 11: Accumulated monthly profit and loss development [in USD]

Figure 12: Profit and loss from interest and from exchange rates per year [in USD]

Figure 13: Annual returns [in USD]

Figure 14: Annual volatilities of the returns

Figure 15: Profit and loss from interest and from exchange rates per year

Figure 16: The circadian Rhythms of the FX Market

List of Tables

Table 1: Conditions and actual investment environments of efficient markets

Table 2: Pool of currencies for the case study

Table 3: Monthly long and short positions in

Table 4: Monthly long and short positions

List of Formulas

Formula 1: Investment in the home market and carry investment

Formula 2: Expected variation of the exchange rate equals the swap rate

Formula 3: Information Ratio

List of Abbreviations

Abbildung in dieser Leseprobe nicht enthalten

1 Problem outline and significance

“You can make an argument for carry to have returns akin to equities,” says Andy Kaufmann at Barclays Capital. “A long-term holding of high-yielding currencies makes sense.”1

1.1 Purpose and Motivation

The latest publication from the Bank of International Settlements in April 2010 indi- cated an average global turnover in foreign exchange of USD 4.0 trillion. Com- pared to the average turnover in April 2007 it increased by 20%.2 A part of this volume is said to be due to carry trades, but it is difficult to figure out the actual size because some carry trade positions are off-balance-sheet items that are diffi- cult to measure.3

The paper deals with the carry trade strategy, which is one possibility of investing in foreign exchange rates. Using this strategy the highest yielding currencies are entered in a long contract (investing money) and the lowest yielding currencies are entered in a short contract (borrow money). The return depends on the interest differential of the interest rates and the movement of the exchange rate. ”As long as the interest rate differential is not compensated by an adverse move of the ex- change rate, the investor can profit from this interest rate differential.”4

The aim of this paper is to explain the carry trade strategy and its theoretical back- ground, especially concerning the international parity relationships. The reader will have the possibility to see the strategy within a case study where the carry trade strategy is simulated. Finally the reader gets in insight of possible returns and risks of this strategy.

1.2 Research question

The main research question: “How does the carry trade strategy work?” is focused on a basic explanation of the carry trade strategy. This question is answered in chapter four including the risk and profitability of carry trades.

The sub-question is: “What is the theoretical background?” This question is focused in chapter two, chapter three and the beginning of chapter four. Chapter seven summarizes this paper and gives the answer if someone should invest money by using this strategy.

1.2 Methodology

The theoretical parts of the paper (chapter two to four) are based on a literature research, which include books as well as articles of different journals. Some banks and financial institutes continuously publish research papers which are also included to cover their insights into the topic.

The methodological parts (chapter five and six) are based on a case study which is the key element of this paper. The analyses are done by using MS-Excel and CEE data from Bloomberg and Reuters. The process for establishing the spread sheet is explained step by step. This enables the reader the reconstruction of the analysed strategy.

1.3 Disposition

The main target was to simulate the carry trade strategy with given data of exchange rates and money market rates during a given time period. The possible profit or loss for this original data was finally figured out. Additionally the result was analysed concerning the information ratio.

To understand the theoretical background of the carry trade strategy the paper starts with a chapter on foreign exchange markets. The characteristics of foreign exchange markets are explained and the efficient market hypothesis is defined.

A main point of the carry trade strategy is the relationship of money market rates and interest rates. Therefore chapter three first addresses the relationships between different parities and second the different parities are explained. Finally the international Fisher effect concludes this chapter.

After having a basic background on foreign exchange markets and different pari- ties, the carry trade strategy as such is explained in chapter four. First the theory of the forward premium puzzle, as the empirical basis for the carry trade strategy, is outlined. Then the characteristics of the carry trade strategy is pointed out. This chapter is concluded with a statement on possible profits and the risk of this strat- egy.

In chapter five the case study is introduced. First some assumptions of the case study like the period under consideration and transaction costs are presented. Then the used money market rates and the used exchange rates are explained, this data are analysed in respect of their volatility. After knowing the important in- puts, the construction of the spread sheet is explained and shown with an illustra- tion. The case study is done for six CEE countries. After calculating the profit of this strategy, the case study is simulated with only five countries, leaving out the country with the worst result. Throughout the analyses of the case study, these two strategies are compared. It has to be considered that the data of 2009 do not rely on a full year, because data were only used from January 2009 to October 2009.

Chapter six concerns the fundamental law of active management including the active return, active risk and the information ratio. These issues are explained shortly and analysed regarding the case study.

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Figure 1: Structure of the paper5

1.4 Terminology

In this paper the terms “carry trade strategy” and “currency carry trade strategy” are used interchangeably if it is not specifically mentioned.

The exchange rate is the ratio of domestic to foreign currency. A rise (fall) in the exchange rate is a depreciation (appreciation) of the domestic currency.

The spot exchange rate is the exchange rate in each period offered for immediate transactions.

A forward exchange rate is the exchange rate for period t+1 agreed on in period t. Just to avoid misunderstandings the notation of numbers is done in the Englishstyle, so the English billion is the equivalent of the German “Milliarde”.

2 Foreign Exchange Markets

Every nation has its own national currency or monetary unit used for making and receiving payments within its own borders. For payments across national borders foreign currencies are needed. To conduct business abroad or engage in financial transactions with persons in other countries, there must be a mechanism for pro- viding access to foreign currencies, so there is need for “foreign exchange” trans- actions - exchanges of one currency for another.6 An exchange rate is the relative price of two currencies. It describes the price of one currency in terms of another currency.7

2.1 Characteristics of the Foreign Exchange Market

A foreign exchange market is a market where a convertible currency is exchanged for another convertible currency. One of them is considered domestic and the oth- er is regarded as foreign, from a certain geographical or sovereign point of view. Foreign exchange markets are not reserved for traders or finance professionals only but for almost everyone.8 There is no difference in foreign exchange markets to other markets where commodities are exchanged and buyers and sellers nego- tiate on the price. In the foreign exchange market the commodity is the foreign cur- rency and the price is the foreign exchange rate.9 The market follows the sun around the earth, so it is a twenty-four hour market, as some centers close, others open and begin to trade. This means that exchange rates and market conditions can change at any time in response to developments that can take place at any time. So market participants must be alert to the possibility that a sharp move in an exchange rate can occur during an off hour, elsewhere in the world. Appendix 1 gives a general sense about participation levels in the global foreign exchange market by tracking electronic conversations per hour.10

As shown in figure 2, the Dollar is by far the most widely traded currency. The Eu- ropean currencies are not very important on the international exchange market when considering the daily turnover. The largest amounts of foreign exchange trading can be found in the United Kingdom. The second largest trades take place in the United States and the third largest in Japan.11

Figure 2: Currency distribution of global foreign exchange market turnover (Percentage shares of average daily turnover in April 2010)12,13

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The foreign exchange market is primarily an over-the-counter market (OTC)14 and increased rapidly during the last decades. For example the market turnover for the currency pair US Dollar/Euro was 372 billion of US Dollars in 2001 and 1,101 billion of US Dollars in 2010, which is an increase of nearly 300%.15

2.2 Efficient Market Hypotheses

The basic assumption of the Efficient Market Hypothesis (EMH) - defined from Fama, E. F. in 1970 - is that prices fully and quickly reflect all available information of the market.16 This market reflects immediately and fully new relevant information and contains numerous of well informed actors with easy access to new information and prices that are rapidly adjusted to new information - this assumes expectations to be rational. Any certain profits from speculation are excluded in the efficient market when prices adjust to new information.17 The key to assess market efficiency is to determine how well information is reflected in prices. In a perfectly efficient market, security prices quickly reflect all available relevant information. Thereof investors are not able to use the available information to earn excess returns because it is already impounded in the prices.18

The following table 1 shows the conditions of an efficient market (left side of table 1) and the actual investment environment (right side).

Table 1: Conditions and actual investment environments of efficient markets19

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The foreign exchange market is sought to have the characteristics of an efficient market and so exchange rates will quickly adjust to any new information.20 The EMH is divided into three categories (see figure 3), depending on the associated information.21

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Figure 3: Three categories of EMH22

The weak form of the hypothesis got its name because security prices are argua- bly the most public as well as the most easily available pieces of information. On the one hand it should not be able to profit from using something that “everybody else knows”, but on the other hand, many financial analysts attempt to generate profits by studying past stock price series and trading volume data with the so called technical analysis.23

The semi-strong form of EMH suggests that the current price fully incorporates all publicly available information. These information does not only have to be of a strictly financial nature and includes not only past prices, but also data reported in a company’s financial statements, earnings and dividend announcements, an- nounced merger plans, the financial situation of a company’s competitors, expec- tations regarding macroeconomic factors (such as inflation, unemployment), etc.24

The strong form of EMH states that the current price fully incorporates all existing public and private information. The main difference, in contrast to the semi-strong form, is that nobody should be able to systematically generate profits even if trading on information that is not known publicly (sometimes also called as insider information) at the time.25

3 International Parity Relationships

The target of the following chapters is the explanation of the relationships between different parities and their influence on exchange rate and interest rate. The chapter starts with an overview of the different parities and illustrates their relationships. It starts with an survey of the interest rate parity and goes on with the purchasing power parity and the unbiased forward rate. Finally the Fisher effect and the international Fisher effect are explained.

3.1 Parities

Parity conditions are an explanation for the long-run value of exchange rates.26 Fundamental elaborations concerning the relationship between interest rates and expected inflation were done by the American money-theorizer Fisher in 1930. He published a paper where he included the domestic and foreign exchange rate as well as the foreign interest rate and the level of price. Also the value of forward exchange contracts is considered. The findings are called Fisher Effect, Interna- tional Fisher Effect, Interest Rate Parity, Purchasing Power Parity and Unbiased Expectations Hypothesis. The relationship of these parities is shown in figure 4.27

Abbildung in dieser Leseprobe nicht enthalten

Figure 4: The International Parity Relationships28,29,30

3.2 Interest Rate Parity

Analyses of behavior in the foreign exchange market frequently rely on the interest rate parity theorem which relates the forward exchange rate to the money market interest differential.31 The interest rate parity links the money market with the financial market, assuming that exchange rates not only define the price of goods but also of financial worth.32

The foreign and domestic asset prices are linked by the uncovered and covered interest rate parities and identify potential returns from investment. The difference between interest rates to the domestic currency’s expected rate of depreciation is equated by the uncovered interest rate parity (UIRP).33 The UIRP condition implies that investors do not need to be compensated, so no risk premium is necessary, for taking on the risk that their expectations may prove to be wrong. The yield spread between foreign and domestic currency deposits should adjust, in the ab- sence of a risk premium, to equal the expected change in the exchange rate.34

The covered interest rate parity (CIRP) condition should exactly yield the invest- ment in a foreign currency deposit, which is completely hedged against exchange- rate risk, and a comparable domestic-currency deposit.35 Explained in detail, an investor could decide to invest in the home currency or in the foreign currency, for example in the Dollar. If he decides to invest in the Dollar, he firstly changes the investment capital (GEUR 0) to the actual exchange rate (w0) to get a USD-amount (GUSD). This USD-amount is invested to the money market rate in the US (iUS) for example for one year. After this year the USD-amount increased by the money market rate (GUSD + iUS) and is exchanged back at the actual exchange rate (w1) into the Euro-amount (GEUR 1). Currency devaluation to the USD additionally in- creases the profit of an US-deposit in Euro, while an upward revaluation cuts the profits. But the exchange rate risk could be eliminated with hedging, because the investor can change the USD-amount already today against the forward exchangerate (f0,1). Thereof it is possible to have a save Euro amount.


1 Garnham (2009) online.

2 see: Bank of International Settlement (2009) p.6.

3 see: Winters (2008) p.7.

4 see: Reischl (2009) p.1.

5 own figure (2011).

6 see: Cross (2002) p.9.

7 see: Cross (2002) p.9.

8 see: Wang (2009) p.1.

9 see: McIntosch (2000) p.1.

10 see: Cross (2002) p.17.

11 see: Grouchko, Kleist, Mallo, Mesny (2010) p.17.

12 see: Grouchko, Kleist, Mallo, Mesny (2010) p.12.

13 note: Because two currencies are involved in each transaction, the sum of the percentage shares of individual currencies totals 200% instead of 100%. Adjusted for local and cross-border inter- dealer double-counting

14 see: Cross (2002) p.21.

15 see: Grouchko, Kleist, Mallo, Mesny (2010) p.15.

16 see: Fama, E. F. (1970) p.383-417.

17 see: Sundqvist (2002) p.18.

18 see: Jones (2010) p.303-304.

19 Jones (2010) p.302.

20 see: Sundqvist (2002) p.18.

21 see: Jones (2010) p.303-304.

22 see: Jones (2010) p.304.

23 see: Clarke / Jandik / Mandelker (n.d.) p.4.

24 see: Clarke / Jandik / Mandelker (n.d.) p.5.

25 see: Clarke / Jandik / Mandelker (n.d.) p.6.

26 see: Jeffus (n.d.) p.2.

27 see: Gantenbein / Spremann (2007) p.101.

28 see: Jeffus (n.d.) p.3.

29 see: Gantenbein / Spremann (2007) p.102.

30 see: Wang (2009) p.61.

31 see: Aliber (1973) p.1451.

32 see: Frieser (2009) p.17.

33 see: Illes (2009) p.1.

34 see: Rosenberg (2002) p.65.

35 see: Rosenberg (2002) p.65.


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theoretical background simulationof carry trade strategy cee-states




Title: Theoretical Background and Simulation of the Carry Trade Strategy within CEE-States