Nice read.
I came across a similar topic related to borrowing in Japanese ¥, but this was related to utilising the borrowing in India, rather than trading with it (carry trade).
Why is India borrowing in Japanese Yen
Also in theory, whenever there is an arbitrage opportunity in the Money market (interest rate), the Currency market should wipe out that arbitrage to maintain parity.
I have read that as per the Interest rate parity theory (IRPT), the currency of the country with the lowest interest rate grow stronger than the country with high interest rate.
So in the Yen-USD example, eventually at the time of redemption of the borrowing, the Yen would have grown stronger and nullified the gains from interest rate differential.
People/Institutions borrow and pay at different times, so it is not necessary to close the arbitrage while paying back, We are calling it the great carry trade because this is the longest trade many are still doing, it will exist till it doesn’t.
Hi,
After reading the above Z-connect post again, i had the following doubt, hope someone could clarify.
Excerpt from the article:
There is a direct correlation between the interest rate and currency movements. If inflation is high, that means something is fundamentally wrong in the economy, and therefore, the central bank tends to increase the interest rate. Such currencies usually depreciate over time.
Alternatively, the currency backed by low interest rates in the economy is considered to be doing well or a strong currency
Here, it says that there is a direct correlation between the interest rate and currency movement, however, i was of the opinion that there was an inverse relationship between the two. And this is confirmed by the following lines in the same article
It says, > increase the interest rate. Such currencies usually depreciate over time"
And
low interest rates in the economy is considered to be doing well or a strong currency
So
Increase in interest rate = Depreciation of currency
Decrease in interest rate = Appreciation of currency
Which means there is a INVERSE correlation is it not ? rather than a direct correlation ?
What am I missing ?.
For proving how there is an inverse relationship i would like to use the IRP theory
(Since this is only a theory, it assumes that the demand and supply for the countries currency is not influenced due to the other activities like imports and exports etc)
According to the IRP theory, the currency of a nation with a lower interest rate should be at a forward premium compared to the currency of a nation with a higher interest rate. (Inverse relationship)
Example Calculation:
Spot INR/USD = ₹83 (hypothetical)
Interest rate in INDIA = 7% (hypothetical)
Interest rate in USA = 4% (hypothetical)
Now, as per the IRPT the forward rate at the end of 1 year will be ₹85.40
1 year Forward rate = [₹83 * (1.07/1.04)] = ₹85.40
So we can see that the INR has actually depreciated in value compared to the USD as per the IRPT.
So does this not mean that the interest rate and the currency value have an inverse relationship.
Obviously this is only a theory, which is meant to determine the future exchange rates so that there is no arbitrage opportunity due to interest rate differential.
But i believe banks do use such interest rates to determine the forward rate for currencies.
PS: Almost 90% of the articles i come across in the internet state the opposite of what I have just stated above, like
Higher interest rates tend to attract foreign investment, increasing the demand for and value of the home country’s currency. Conversely, lower interest rates tend to be unattractive for foreign investment and decrease the currency’s relative value (meaning there is a direct correlation)
Source: Investopedia
I am confused
Any clarification on this will be much appreciated.
Sorry, about the confusion
By direct correlation, I mean anything that happens with X, has and impact on Y. So ‘direct’, in this sense is more colloquial rather than to be mathematically correct.
This carry trade is being there from many years , may be as old as equal to or greater then my age
Hi,
Happy to get a reply from you, I really loved all your varsity content and the way you explained and presented the YouTube videos.
Keep up the good work. Can’t express how nice it feels to talk to you.
Leaving the Fanboy moment aside.
Can you confirm which of the above two theory is correct.
Like i mentioned, I feel there is an indirect relationship between Interest rate and currency movement.
But almost every content I find on the internet states the opposite. Like, when the country increases its interest rates, it currency gains value as it attracts more FDI resulting in demand for the Currency.
But this argument fails to make sense because, normally interest rates are raised to curb inflation and in such a condition the economy of the country slows down Making it currency depreciate rather than appreciate.
Hope you can clarify.
Sorry if I am troubling you.
Thank you
I like to think of Currency rates as option premiums. The option premiu is not just impacted by the underlying’s directional movement but also by volatility, the speed at which the market is moving, time to expiry, demand, supply, and the cost of carry.
Each of these factors either tend to increase the premium or decrease the premium.
Likewise, the FX rate will also depends on multiple factors. What makes it complicated is that none of these factors play out in isolation. While a weak Govt tends to drag the currency down, a low interest rate tends to strengthen it. Higher interest rate tends to weaken the currency, but yes, like you said FDIs tend to boost the FX.
It’s impossible to isolate one factor and gauge its impact because in a real-life economy, multiple factors play out simultaneously.
Hope that helps.
Yen’s Appreciation Is Affecting Carry Trade
Yen's Surge: How Japan's Interest Rate Hike is Disrupting Global Markets and Carry Trade
Hiii, I’m a btech 4th yr student trying to learn the how nd why of stock market.
I saw ur post related to ICICI ipo bid price calculation.
Can you please explain me how do we actually calculate or judge if an ipo is worth investing.
Also as a beginner can you please suggest me which IPOs I should try for and at what bid price.
It would be great if you could help.