New Delhi, July 15 -- Assume that a non-resident Indian (NRI) takes a 162 million yen loan at, say, 4% interest per annum and converts it to $1 million. This amount can then be put in a foreign currency non-resident (FCNR) deposit at an interest rate of, say, 6.5% for 3 or 5 years.

The bank gives these dollars to the Reserve Bank of India (RBI), which in turn swaps them without any risk premium. This means that the bank can buy back the dollars at the present exchange rate at the time of maturity. Sounds good? Yes, this is how carry trade works, but the difference is that banks would normally not pay such high rates of interest, given the foreign exchange risk they bear, as reflected in the forward hedging rate of around 3%.

The rupee h...