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Evidence of carry trade activity 1
Interest rate differentials have been a driving force behind exchange rate movements in recent years. This has focused market attention on the role of currency carry trade positions, and on the possibility that a sudden unwinding might adversely affect financial stability. However, carry trades are notoriously difficult to track in the available data. This special feature first outlines the investor base and trading strategies used in carry trades, and then explores various sources of data to gauge activity.
JEL classification: F31, F32, G15.
Low exchange rate volatility and persistent interest rate differentials have underpinned significant cross-currency positioning in recent years. These positions have often taken the form of currency carry trades, or leveraged cross-currency trading strategies. To the extent that this carry trade activity has been, and may continue to be, an important driver of exchange rate developments, it is useful to gauge what the available data can say about its significance. The effect of carry trade activity on exchange rates is typically asymmetric, and can be significant. The build-up of these positions generally contributes to a steady strengthening of target currencies (associated with high interest rates) and a weakening of funding currencies (associated with low interest rates), against the predictions of the uncovered interest parity (UIP) hypothesis (Burnside et al (2006, 2007)). However, when changes in interest rate expectations or volatility lead to a sudden unwinding of carry trades, there is a tendency for target currencies to depreciate and funding currencies to appreciate sharply (IMF (1998), Béranger et al (1999), Cairns et al (2007), Gagnon and Chaboud (2007)). Perhaps the best known example is the sharp... [continues]
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