CURRENCY RISK IN EMERGING MARKETS
Amit Patel (070026966)
Currency Risk in Emerging Markets
Msc Mathematical Trading and Finance
Project Semester B
By
AMIT PATEL
Student No. 070026966
CASS BUSINESS SCHOOL
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CURRENCY RISK IN EMERGING MARKETS
Amit Patel (070026966)
SMM609
PROJECT ASSESSMENT TRANSCRIPT
Student Name:
Session:
Amit Patel
Student Number: 070026966
Project Title:
Semester Start: B
Course: MSC MTF
CURRENCY RISK IN EMERGING MARKETS
Project Tutor: Dr. Dan Oprescu
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CURRENCY RISK IN EMERGING MARKETS
Amit Patel (070026966)
ABSTRACT
Emerging market currencies have always attracted investors due to high premium
associated with it. Premium here defined as returns due to interest rate differential or
carry trade and returns from capital gains. However Emerging market currencies (EMC)
tend to reflect relatively high risk averseness due to certain factors which makes them
very risky investments.
My aim in this project is to evaluate the factors or risk associated with EMC theoretically
in order to understand risk and practically by proposing a investment fund and evaluating
risk of EMC portfolio. This project also includes major event risks like Asian crisis 97’
and Credit crisis 07’ which exhibit risk associated with EMC.
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CURRENCY RISK IN EMERGING MARKETS
Amit Patel (070026966)
AKNOWLEDGEMENT
This study would not have been possible without the support and assistance of a number
of people and organizations as well as my family. Mr Babulal Patel, father to me, was the
source of the inspiration and incentive to begin the research effort. He provided critical
assistance along the way. His help was invaluable as he is a FX trader and conducts
research in FX and Commodity market since 15 years.
Members of my staff assisted with this study in myriad ways. Especially I am grateful to
Mr Dan Oprescu who allowed me to do this project and who was all the way helpful
towards my successful completion of project.
No study of this size can be completed without disruption of one’s normal family and
work routine. This project could not have been completed without the support,
encouragement, and love and caring of my family and work mates due to their
exceptional support.
The Precious knowledge attributes of this report are derived from those mentioned above,
from my 4 years of trading experience and many other internet sources . The conclusions
and any errors, omissions or mistakes within this report are attributable only to the author.
Best regards,
Amit Patel
Cass Business School
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CURRENCY RISK IN EMERGING MARKETS
Amit Patel (070026966)
TABLE OF CONTENTS
ABSTRACT ................................................................................................................... 3
TABLE OF CONTENTS ............................................................................................... 5
PROJECT OUTLINE .................................................................................................... 6
TITLE ............................................................................................................................ 6
AIMS.............................................................................................................................. 6
CHAPTER ONE ............................................................................................................ 7
WORLDWIDE EMERGENCE OF CARRY OVER TRADES .................................... 7
1.0
INTRODUCTION ............................................................................................. 7
1.1 Risk Averseness ........................................................................................................ 7
1.2 Geo-Political Risk ................................................................................................... 11
1.3 Fundamentals and Risk ........................................................................................... 12
1.3.1 Inflation ............................................................................................................ 12
1.3.2 Growth and Reliance....................................................................................... 14
1.3.3 Debt .................................................................................................................. 14
1.3.4 Liquidity Risk .................................................................................................. 18
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CURRENCY RISK IN EMERGING MARKETS
Amit Patel (070026966)
PROJECT OUTLINE
TITLE
Currency Risk in Emerging Markets.
AIMS
This project investigates the risk associated investing in Emerging Market Currencies
(EMC). The initial research includes how geo-political news, fundamentals, risk
averseness, traders pose a risk to EMC. Further the project through inclusion of charts
and statistics depicts to what extent factors can cause risk to EMC. Finally I will propose
an EMC Investment Fund for practical evaluation of risk.
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CURRENCY RISK IN EMERGING MARKETS
Amit Patel (070026966)
CHAPTER ONE
WORLDWIDE EMERGENCE OF CARRY OVER TRADES
1.0 INTRODUCTION
Carry over trade is a term associated with the interest rate differential between high and
low yield currencies. As for example borrowing Japanese yen (JPY) at 0.50% LIBOR
and investing in high yield currencies like Turkish Lira (TRL) at 17.5% LIBOR.
Emerging markets tend to have high interest rates on local currencies in order to cope
with inflation and prevent the economy from overheating. This factors tend to depend
from country to country. Due to such a large premium investors are attracted towards
emerging markets compared to other industrialised nations like US or Germany. However
there is a catch as investors receiving high premium have to evade losses related to
exchange rate. Below are the factors which have been identified as risk related to EMC.
1.1 Risk Averseness
Emerging Market Currencies (EMC), no doubt have provided more returns compared to
G7 currencies but due to its high volatility and less volume together with the factor of
risk averseness classify as extremely risky asset instrument. Risk averseness is defined as
massive sell off or unwinding of carry over trades due to certain major event risk or
uncertainty in financial markets. In such cases investors tend to withdraw their
investments from emerging markets and invest in safe-heaven assets like Gold or
Treasuries. An example to what extent it can affect EMC is described below in the chart.
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CURRENCY RISK IN EMERGING MARKETS
Amit Patel (070026966)
Courtesy: [Saxobank Trader]
Above is daily chart for spot Turkish Lira/ Japanese Yen (TRY/JPY) which shows a fall
of 20.34% in July 07’ when credit crisis hit financial markets which is an example of
unwinding of carry trades.
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CURRENCY RISK IN EMERGING MARKETS
Amit Patel (070026966)
Courtesy: [Saxobank Trader]
Another example of South American region we have USD/MXN which slided 5.98% in
a weeks time due to risk averseness.
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CURRENCY RISK IN EMERGING MARKETS
Amit Patel (070026966)
Courtesy: [Saxobank Trader]
In Europe there was same effects which can be seen in USD/ISK( Dollar/Iceland Koruna)
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CURRENCY RISK IN EMERGING MARKETS
Amit Patel (070026966)
Courtesy: [Saxobank Trader]
In the African Continent we can see South African Rand adversely affected by a fall of
11.76% in a week’s time during July 07’.
Thus we can conclude that in the event a major financial crisis is hit traders or investors
tend to become extremely cautious and become risk averse which leads to massive selloff or unwinding of carry trades.
If an investment firm is able to understand such theories then it can re adjust its positions
in order to avoid further losses. It might be true that trader and investors may have
readjusted their positions sighting credit crisis 07’ from historical event crisis like Asian
crisis 97’
1.2 Geo-Political Risk
Emerging market politics and monetary polices tend to affect local currencies. For
example elections in Brazil or Turkey do tend to have considerable impact on their
respective currencies as investors evaluate the future monetary policies. Emerging market
politics is a sensible issue because it tends to reflect what sort of attitude the new political
regime in a certain country will have towards other countries.
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CURRENCY RISK IN EMERGING MARKETS
Amit Patel (070026966)
Further certain factors like wars(Gulf war), military coup(Thailand), civilian
crisis(Pakistan, Kenya), Terrorist threat or attacks also pose serious threat towards EMC
and can trigger unwinding of risky assets due to safe-heaven buying.
1.3 Fundamentals and Risk
Fundamentals like Inflation, Debt, Growth and reliance affect the long-term outlook of
currencies.
1.3.1 Inflation
Inflation is a primary risk to emerging markets. Emerging countries like China, India,
Russia, Brazil (BRIC) have stepped in several times by increasing interest rates in order
to control inflation. One of the major factors of increase in inflation is rise in Crude oil
and Commodity prices. Most of the emerging markets having limited energy resources
heavily import crude oil which thereby increases their trade deficits as well.
Higher inflation rate increase prices of consumer goods and other industrial materials and
hence affect the exporters which fetch revenue for emerging countries. The fact about
emerging countries is heavy reliance on export related revenue in Dollar terms example
China, Brazil and India. An example of extremely high inflation, limited foreign
exchange reserves in USD and low investor confidence had lead to devaluation of
Argentina Peso during 2002. The charts of Inflation data and exchange rate fluctuation
are shown below. The devaluation of Argentinean peso had affects on its neighbouring
trade partners like Brazil and Mexico to greater extent as well.
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CURRENCY RISK IN EMERGING MARKETS
Amit Patel (070026966)
Pablo,f., 2006,Monthly inflation in Argentina in 2002[online]. Available from
http://en.wikipedia.org/wiki/Image:Monthly_inflation_in_Argentina%2C_2002.png#file
Accessed [ 11th Feb 2008]
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CURRENCY RISK IN EMERGING MARKETS
Amit Patel (070026966)
Source: [ Pacific Exchange]
1.3.2 Growth and Reliance
As emerging markets rely heavily on industrialised nations like US and EU for exports
and slowdown or recession concerns can erode the emerging market earnings. For
example growth forecast is lowered in emerging markets or stock market returns decrease
which significantly affect the currencies. This affect can be seen on the aftermath of
credit crisis 07’ which has significantly affected emerging market currencies due to US
recession concerns which is world’s largest economy by far.
1.3.3 Debt
Emerging Countries tend to have debt in dollar terms and hence is vulnerable to exchange
rate risk and the corporate or companies have to convert their local currency earning to
USD and repay the loans. In the event of any crisis causing large capital companies
bankruptcy can drastically affect investor sentiment which can serious devaluation of
local currency. As for example in Latvia 85 % of household and corporate debt is in
foreign currency and in Hungary 80% of the mortgages taken out have been funded
through carry over trades or low yield currencies.
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CURRENCY RISK IN EMERGING MARKETS
Amit Patel (070026966)
Moneyweek,2007, Swiss france carry trade props eastern Europe[online]. Available
from http://www.moneyweek.com/file/36046/swiss-franc-carry-trade-props-up-easterneurope.html. Accessed [ 11th Feb 2008]
The Asian crisis 97’ was a combination of excessive debt hold by some of the emerging
Asian countries and wide exchange rate fluctuations due to devaluations as well. A
contagion effect could be seen by analysing the charts shown below where countries like
Singapore, Thailand, Philippines, South Korea, Malaysia and Indonesia which were hit
by atleast 30% fall. The worst affected was Indonesian Rupiah which fell from 4000
Rup/Usd to 14000Rup/Usd in a time period of 1 month.
Source: [ Pacific Exchange]
http://fx.sauder.ubc.ca/plot.html
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CURRENCY RISK IN EMERGING MARKETS
Amit Patel (070026966)
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CURRENCY RISK IN EMERGING MARKETS
Amit Patel (070026966)
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CURRENCY RISK IN EMERGING MARKETS
Amit Patel (070026966)
1.3.4 Liquidity Risk
EMC compared to Industrialised country currencies like Usd, Jpy or Euro have high
liquidity risk due to low volumes in trading. For example the daily turnover in foreign
exchange markets is $3.2 Trillion according to a survey of Bank of International
Settlements (BIS).
Finfacts,2007, Global daily turnover in currency markets rises to $3.2
trillion[online]. Available from
http://www.finfacts.com/irelandbusinessnews/publish/article_1011278.shtml. Accessed
on[ 12th Feb 2008]
The share of EMC’s like Mexican Peso ( 1.3%), Brazilian Real ( 0.4 %), Turkish Lira
( 0.2%), Indian Rupee ( 0.7% ), Korean Won ( 1.1 %), Polish Zloty ( 0.8%) is merely
small compared o G7 (Industrialised Nations) like Usd ( 86.3%), Jpy ( 16.5%).
Bis.org,2007, Triennial central bank survey of Foreign Exchange and Derivatives Market
activity[online]. Available from http://www.bis.org/publ/rpfx07.pdf
Accessed on [ 12th Feb 2008]
Hence in the event of financial crisis the spreads between bid and ask increase drastically
for EMC’s and in certain cases liquidity almost dries up. This can cause big swings in
volatility of currencies which in turn can have adverse affect on investment portfolio
consisting EMC.
The Volatility charts of Brl/Jpy (Brazilian Real/Japanese Yen) and Zar/Jpy( South
African Rand/ Japanese Yen) respectively. The volatility charts which have been soured
from Bloomberg show a high volatility swings in July-August(Credit Crisis) period
which can be very risk from investors point of view.
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CURRENCY RISK IN EMERGING MARKETS
Amit Patel (070026966)
SOURCE : [BLOOMBERG]
SOURCE : [BLOOMBERG]
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CURRENCY RISK IN EMERGING MARKETS
Amit Patel (070026966)
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