• 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

1. change in the exchange rate over the previous month

2. size of the interest-rate gap between each currency

3. 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

Author: Rahul Sonthalia, Analyst, Kredent Group

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