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