Can Carry Trade Make Real Wealth

• Carry trade strategy : buying (investing in) a high interest yielding currency and selling (borrowing) a low yielding currency
• Yen is favoured funding currency for the carry trade due to low interest rates in Japan
• Dollar has become the next favoured one due to the economic crisis and near-zero rates in America
• In an effecient market, carry trades are profitable as the extra interest earned is offset by the fall in the target currency
• Hence, high-interest currencies trade at a discount to their current or “spot” rate in forward markets
• If exchange rates today were the same as those in forward contracts, there would be an opportunity for riskless profit
• In practice, the forward market is a poor forecaster
• Most of the time exchange rates do not adjust to offset the extra yield being targeted in carry trades
• Carry trades are prone to infrequent but huge losses
• As per a study by Òscar Jordà and Alan Taylor of the University of California, Davis, a refined carry-trade strategy produces more consistent profits and is less prone to huge losses than one that targets the highest yield
• In their study, they found that the following three things influenced the currency movements in short term

o change in the exchange rate over the previous month

o size of the interest-rate gap between each currency

o size of inflation gap between each currency

• These impulses can drive exchange rates a long way from their fair or “equilibrium” values leading to losses
• To guard against this, the authors added to their model a measure of how far the exchange rate has shifted from its fair value
• Modifications were made to the model to reflect non-linear link between profits and yield and the likelihood of a crash escalating with a currency becoming dearer
• The trade, based on the model, might well turn out to be profitable but the forgone profit is a small price to pay for avoiding a potentially big loss
• However, the authors stress that their approach was better than the simple one at predicting the direction of exchange rates

Partly Correct-Partly Incorrect

In one of my earlier posts titled “Sell equity and Base Metals” I had said that Euro is reaching a crucial level of around 1.5 and is expected to correct from here, leading to a correction in Gold prices, Crude, other metallic commodities and equities.

What has happened that the dollar has gained considerable strength form there trading at a levels of around 1.46, gold has corrected to almost $1120 and crude along with other metals have also plummeted quite significantly. However, the only thing that did not go as I said was the Indian equity markets.

At the time when most of the commodities, oil and the global financial markets were falling, the Indian Nifty index stood all up just giving some sideways movement. This indeed was very surprising for, since this whole rally was because of a weaker dollar and was expected that with dollar gaining strength, the rally will fade away. However, this belief was put completely wrong by the market.

This could mean two things

• First and the one which everybody on TV is shouting is that the Indian markets have decoupled and now we are in a bull market of our own and India does not need to follow the global clues too stringently
• The other could be, which I am very fearful of is that on one fine day we may fall like the day we did in January last year. This was exactly the case to the two weeks leading to 21^st January 2008. On one hand all the global markets were correcting, while on the other the Sensex was scaling new heights everyday and then on 21^st fell by over 1000+ points on a single day

I strongly believe that one should remain very cautious now until the Nifty breaks pass the strong 5200 levels and only initiate a long position then. This is because a falling oil and commodity prices seriously hurts the bottom line of almost 45% of Nifty 50 companies. Moreover, what is going on since years could not change over one week and hence the question of decoupling does not arise.

If a falling Dubai can create vibrations in Indian stock market, a rising dollar has the power to cause an earthquake

Thus, currently the best trading strategy would be to go short with a stop loss of around 5200 Nifty.

October IIP Update

• The IIP figure for October stood at 10.3%, disappointing everybody since the expected figure was hovering around 12%.The same index registered a growth of -0.4% y-o-y in Oct’08 whereas a growth of 9.6% (revised) y-o-y in the last month

• The figure was below the market expectations, leading to a fall of 50.41 points in the Sensex, pulling it down from 17,189.31 to 17,138.90, just after the release of the data. Since the market was expecting a better number, all the gaining sectors lost their momentum and took a back step

• The figure will also help RBI for the interest-rate decision for January. But, the figures are still not bad for they have again hit a double-digit growth for the second time in three months. Acc. To Montek Singh Ahluwalia.the figure is strong enough to indicate that India’s IIP is still in good shape and the trend will continue in future

• The manufacturing sector grew by 11.1% y-o-y compared to -1.2% in Oct’08 y-o-y on account of increased manufacturing activities. This sector has seen a major correction in its numbers. The electricity sector increased to 4.7% from 4.4% in Oct’08 y-o-y. Manufacturing and electricity sectors both grew by 9.3% & 7.9% respectively in Sep’09

• The mining sector, posted a growth of 8.2% against 2.8% in the same month of the last year. It grew by 8.6% in Sep’09 y-o-y respectively. It has been consistently showing good performance since the last 3-4 months

• In the use-based category the basic goods, capital goods and the intermediate goods sector registered a growth of 5.0%, 12.2% and 14.3% y-o-y respectively compared to 2.7%, 3.1% and -3.7% y-o-y respectively in Oct’08. All the three sectors have performed extremely well: especially the capital goods segment which posted negative figures for around 3-4 months starting from March

• The consumer goods sector has grown by a satisfactory 11.8% y-o-y compared to its growth of -2.3% in Oct’08 y-o-y. The sector’s growth got injected by a boost in the consumer durables segment which grew by 21.0% y-o-y, a huge increase from -3.0% in Oct’08 y-o-y. Even the consumer non-durable goods performed stupendously registering a growth of 8.1% compared to a growth of -2.0% in Oct’08. It has been performing meagerly since last 4-5 months, registering low growth figures since last few months and even negative at times

• The IIP figure for October stood at 10.3%, disappointing everybody since the expected figure was hovering around 12%.The same index registered a growth of -0.4% y-o-y in Oct’08 whereas a growth of 9.6% (revised) y-o-y in the last month

• The figure was below the market expectations, leading to a fall of 50.41 points in the Sensex, pulling it down from 17,189.31 to 17,138.90, just after the release of the data. Since the market was expecting a better number, all the gaining sectors lost their momentum and took a back step

• The figure will also help RBI for the interest-rate decision for January. But, the figures are still not bad for they have again hit a double-digit growth for the second time in three months. Acc. To Montek Singh Ahluwalia.the figure is strong enough to indicate that India’s IIP is still in good shape and the trend will continue in future

• The manufacturing sector grew by 11.1% y-o-y compared to -1.2% in Oct’08 y-o-y on account of increased manufacturing activities. This sector has seen a major correction in its numbers. The electricity sector increased to 4.7% from 4.4% in Oct’08 y-o-y. Manufacturing and electricity sectors both grew by 9.3% & 7.9% respectively in Sep’09

• The mining sector, posted a growth of 8.2% against 2.8% in the same month of the last year. It grew by 8.6% in Sep’09 y-o-y respectively. It has been consistently showing good performance since the last 3-4 months

• In the use-based category the basic goods, capital goods and the intermediate goods sector registered a growth of 5.0%, 12.2% and 14.3% y-o-y respectively compared to 2.7%, 3.1% and -3.7% y-o-y respectively in Oct’08. All the three sectors have performed extremely well: especially the capital goods segment which posted negative figures for around 3-4 months starting from March

• The consumer goods sector has grown by a satisfactory 11.8% y-o-y compared to its growth of -2.3% in Oct’08 y-o-y. The sector’s growth got injected by a boost in the consumer durables segment which grew by 21.0% y-o-y, a huge increase from -3.0% in Oct’08 y-o-y. Even the consumer non-durable goods performed stupendously registering a growth of 8.1% compared to a growth of -2.0% in Oct’08. It has been performing meagerly since last 4-5 months, registering low growth figures since last few months and even negative at times

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Dubai's Debacle and India..

I was on vacation for a week and all of a sudden amidst the desert of Jaisalmer saw Indian markets crashing like anything. Called up one of my colleagues in Kolkata and he told that the sell of today is because some kind of a debt default by a company from Dubai (another desert place).

The first thing that came to my mind, is since when the global markets have started following DUBAI..!! But when I came back and read some news articles and reports by eminent houses like CLSA and Citi group, the sell off really made sense.. at least for India, if not for the rest of the world. This is mainly because:

• Indian are ~40% of UAE’s population; forming ~10-12% of India’s inward remittances. Thus a debacle in UAE could really hurt remittances into India and also increase unemployment
• UAE forms ~8% of India’s non-oil exports
• DP World operates five container terminals in India, accounting for 40% of India’s container traffic
• A lot of JVs between Indian and Dubai based firms are operational in Indian Real estate domain (Emmar- MGF, DLF-Limitless, etc) and this could severely impact real estate prices in India
• Good for India, Indian banks does not have any materialistic loan exposure to companies in Dubai

What exactly happened is that Dubai’s failure re-awakened a number of dormant fears in investors that the worst probably is over,but the things are definitely back to 100% normal. Dubai which was potraying itself as a gateway to the financial world has being held in a sandstrom it has created on its own.

Thus in the coming few days, it would be good to remain cautious on the global capital market recovery and the best strategy is to go short with a stop loss of around 5200 on Nifty Index on a closing basis. Because the way media has waved off this Dubai Debacle in a day or two is actually a cause of concern since the crisis looks bigger than it is being portrayed as.