Rupee depreciation has resulted in lower returns for traders who have borrowed in dollars to invest in rupee (dollar carry trade) over the last 12 months.
According to Bloomberg, the carry trade between the dollar and rupee that involves selling dollar and buying rupee has yielded marginal return of close to 1 per cent over the past year. Carry trade returns include the interest rate difference in the two currencies and the gain/loss made by currency movement. The rupee depreciated about 8 per cent against the dollar over the past year but higher interest rate differential around 9 per cent compensated for the depreciation, thus making this strategy slightly profitable.
Under carry trade, investors borrow in a currency with low interest rate to invest in high-yielding currency or riskier assets such as stocks and commodities which generate higher returns. Traditionally carry trade loans were taken in Yen and Swiss Franc due to lower borrowing cost in these currencies. The carry trade can lose money when the currency used to fund the strategy strengthens, or the targeted currency weakens.
Dollar has emerged as a new funding currency for carry trade after successive quantitative easing by US Federal reserve. The low interest rate in the US which is close to 0.25 and expectations that it will remain so till late 2014 has also fuelled these trades.
The best carry trade strategies involving selling the dollar were in Latin American currencies. For instance, investing in Chilean peso, Colombian peso and Peruvian Nuevo provided a return of 10.2, 9.4 and 8.18 per cent respectively. In the list of top ten carry trades, two carry trade strategies, with Turkish Lira and Egyptian pound had a negative spot returns. In other words, these currencies depreciated but this decline was compensated by a high yield differential. Turkish Lira and Egyptian Pound had yield differentials of 9.29 and 9.21 per cent respectively.
The worst performing carry trades list was led by Brazilian Real with a negative return of 8.43 per cent. Despite higher interest rate differential of 7.1 per cent, depreciation of about 14.5 per cent in the Real was responsible for the negative return.