7.

a) Explain what does a carry trade mean and state its characteristics.

A carry trade is trading strategy that involves borrowing money very cheaply and deposing it
in another country that has very high short rates. If everyone follows that path, then the
currency goes up and we shall make a capital gain, plus earning a high yield, which means a
double gain. It`s a risky trade, that is based on the volatility of the currencies.

b) Explain the relationship between carry trade and the UIP condition.

Uncovered interest rate parity (UIP) states that the difference in interest rates between two
countries equals the expected change in exchange rates between those two countries.
Theoretically, if the interest rate differential between two countries is 3%, then the currency
of the nation with the higher interest rate would be expected to depreciate 3% against the
other currency.
In reality, however, it is a different story. Since the introduction of floating exchange rates in
the early 1970s, currencies of countries with high interest rates have tended to appreciate,
rather than depreciate, as the UIP equation states. This well-known conundrum, also termed
the “forward premium puzzle,” has been the subject of several academic research papers.
The anomaly may be partly explained by the “carry trade,” whereby speculators borrow in
low-interest currencies such as the Japanese yen, sell the borrowed amount and invest the
proceeds in higher-yielding currencies and instruments. The Japanese yen was a favorite
target for this activity until mid-2007, with an estimated $1 trillion tied up in the yen carry
trade by that year.
Relentless selling of the borrowed currency has the effect of weakening it in the foreign
exchange markets. From the beginning of 2005 to mid-2007, the Japanese yen depreciated
almost 21% against the U.S. dollar. The Bank of Japan’s target rate over that period ranged
from 0 to 0.50%; if the UIP theory had held, the yen should have appreciated against the U.S.
dollar on the basis of Japan’s lower interest rates alone.

c) How did the recent financial crisis affect the carry trades?

The carry trade strategy was originally highly profitable, but its success was often dependent
on the movement of currency exchange rates. As long as the yen was depreciating, investors
made huge returns. The unwinding of the carry trade strategy therefore intensified the impact
of the financial crisis on emerging markets.
The carry trade strategy fell apart after the bailouts of institutions like Bear Stearns and the
collapse of Lehman Brothers in 2008. Lehman Brothers were allowed to go bankrupt without
full protection for its creditors or those who it had financial contracts with. This meant that
there was panic in the system on a global scale. Confidence fell sharply and financial
institutions in Japan were not willing to indulge in lending for carry trades anymore.
They consequently stopped providing as much credit to local and foreign traders, meaning
that the value of the yen increased sharply since there was no longer as much outflow of
capital. In addition, any debts owed by hedge funds to Japanese institutions suddenly became
much larger in value, due to currency appreciation, which damaged their ability to repay.
There was a wave of defaults and banks in countries like Iceland and Brazil, who were thus
on the brink of financial insolvency due to huge losses faced on their loans. In any case,
traders were forced to withdraw money from countries which originally had high interest rates
like Brazil and Iceland in order to repay some portion of their debts, meaning that their
currency values weakened significantly.
This was a crisis in itself but was made worse by the fact that hedge funds who had borrowed
in one currency and lent in another now suffered huge losses. Such effects suggest that the
carry trade strategy was partially responsible for making the 2007 financial crisis a
multinational one instead of one simply confined to US banks.
8.
a) Describe the economic, financial, and political environment in which the European
Central Bank (ECB) conducts its monetary policy.

Under normal conditions, the single monetary policy exerts influence on the economy mainly
through the interest rate channel.
The deterioration of the functioning of the interest rate and credit channels applies significant
constraints on the activity of non-financial companies (especially in the case of SMEs), given
the reduced substitution capacity between bank loans and other sources of financing.
The continuous deterioration of the state of public finances in some Member States, the
economic recession and the fragility of the financial situation of the banks have led to an
increase in the heterogeneity of the financing conditions between the member states,
respectively to the deterioration of the banks' access to finance and consequently their ability
to credit. the real economy.

b) Describe ECB’s current monetary policy: what decisions has the bank taken? What are
the reasons behind them?

Liquidity was injected into the market as a response to the liquidity shortage, which was a
serious problem before the collapse of the Lehman Brothers. The liquidity crisis in the first
phase of the financial crisis left its place to a confidence crisis in the second phase (Durré, et
al. 2014:403). This was a result of the uncertainties about payment of the debt that started to
emerge in the market after the collapse of the Lehman Brothers as the financial system had
too many risk assets within itself (Claessens, et al. 2010:13). In this regard, the European
Central Bank introduced non-standard monetary policy tools along with the standard ones
following the collapse of the Lehman Brothers. In coordination with the central banks of other
developed countries (Fed, Bank of England, Bank of Canada, Sveriges Riksbank, and the
Swiss National Bank), the ECB decreased the short-term interest rates used as standard policy
tools.
Non-standard monetary policy tools were adopted to support the standard monetary policy
tools and help the transmission of monetary policy to the economy (Giannone, et al. 2011:16).
But, it is quite important to emphasize one point. It is out of the question for the ECB in
particular to put non-standard monetary policy tools in effect after short-term interest rates fall
to the lowest level, thereby loosing function. When short-term interest rates are set to ensure
price stability, the transmission of the policy tool to the economy may not happen in case of a
crisis. Non-standard monetary policy tools are used to make the transmission possible again.
In other words, standard and non-standard monetary policy tools used in the Euro area are, to
a great extent, independently determined. Standard policy tools are determined taking medium
and long-term price stability into consideration. Non-standard monetary policy tools are
adopted to activate the transmission mechanism. Non-standard monetary policy tools
introduced by the ECB were implemented not to replace but to support the standard policy
tools.
c) Explain what do you expect should happen with the euro exchange rate if the ECB
decides to further cut key interest rates.

I think that a country that attempts to adopt a systematically different interest rate policy than
another country simply will not be able to have a fixed exchange rate with that country unless
it imposes capital controls.
d) Analyze the price movements of the EURUSD currency pair throughout 2016.
Comment on the effect that the ECB’s decisions around the appearance of this article
(end of April 2016) had on the currency rate (PrtSc and insert the chart that you used
in your analysis!).

Anemic growth and low inflation numbers have plagued the eurozone economy right from the
beginning. This year started no different. On January 1, 2016, the euro was worth $1.08. It
rose to $1.13 on February 11, as the Dow fell into a stock market correction.
Hence, when the ECB President Mario Draghi unleashed a series of measures aimed at
stimulating the eurozone economy, the Euro fell initially by 1.6%.
The ECB cut deposit rates by 10-basis-point, included corporate debt in its bond buying
program, and cut its marginal and refinancing rates.
However, the currency did a ‘U’-turn and rallied when Draghi said that he did not expect
further easing, though rates would remain low for long.
After continuing its rally, the EUR/USD pair topped out on 03 May 2016.
It remained within a range until the United Kingdom voted to leave the European Union on
June 24. The euro then fell to $1.11 the next day as traders predicted that the consequences of
Brexit would weaken the European economy. On Monday, it fell to $1.10.
The markets calmed down after realizing that Brexit would take years. The euro rose to $1.13
on August 23. It then fell to its 2016 low of $1.04 on December 20, 2016. Italy's presidential
election increased the risk that its banks would not regain its health. It rose to $1.06 by
December 30, 2016.