An Empirical Analysis of Currency Carry Trade Strategies

Topics: Foreign exchange market, Currency, Exchange rate Pages: 26 (7412 words) Published: December 21, 2012
AN EMPIRICAL STUDY OF CURRENCY CARRY TRADE STRATEGIES

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Table of Contents

INTRODUCTION AND LITERATURE REVIEW .......................................................................... 3 MONETARY POLICY IMPLICATIONS ..................................................................................................... 4 POSSIBLE SOLUTIONS OF THE “FORWARD PREMIUM PUZZLE”......................................................... 6 DATA DESCRIPTION......................................................................................................................... 9 METHODOLOGY.............................................................................................................................. 12 EMPIRICAL RESULTS .................................................................................................................... 18 CONCLUSION.................................................................................................................................... 26 APPENDIX .......................................................................................................................................... 27 BIBLIOGRAPHY ............................................................................................................................... 31

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Introduction and Literature review
The carry of an asset is the benefit one receives (if it is positive) or the cost one incurs (if it is negative) by holding it for a period of time. One can think of commodities where the holder of the asset incurs the cost of storage (grain silo rent, bank vault rent for gold bullion, etc.). We have positive carry in case of currency pairs if we take long position in the currency with the higher interest rate (investment currency) and a corresponding amount of short position in the currency with the lower interest rate (funding currency). This is not a case of arbitrage: arbitrage means risk-less profit but in the case of carry trade the trader only achieves profit if the market does not move against the carry position. Interest rates might change for the two currencies involved and exchange rate changes might turn an initially profitable position into a losing one. Positive carry profits seem attractive, however our economics intuition tells us that there is no free lunch. Therefore we assume that in case of positive carry, profits from the carry position should be offset by a corresponding loss due to an adverse change in the exchange rates. This hypothesis is called the uncovered interest rate parity (UIP) assumption. This logic behind the UIP assumption is appealing, however empirically we see quite the opposite happening: the investment currency even tends to appreciate compared to the funding currency (Burnside et al (2006, 2007)). The violation of the UIP is considered to be a foreign exchange market anomaly and is referred to as the “forward premium puzzle”. This is exactly the phenomenon that makes carry trade remarkably profitable: there is a consensus in the literature that the carry trade strategy yields high average payoffs as well as Sharpe ratios that are significantly higher than those of equity investments in the U.S. stock market (Burnside, Eichenbaum, Kleshchelski, Rebelo (2011)). Because of its importance, both practical and theoretical it is one of the most thoroughly researched areas in finance. While the practical

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importance is obvious, there is significant amount of money left on the table, the theoretical importance is more elusive, albeit similarly important: if we can not find a rational explanation to the violation of the UIP we should drop the Efficient Market Hypothesis altogether.

Monetary Policy Implications
Research interest is due partly to the profit opportunities inherent in carry positions but also due to its monetary policy implications. If higher interest rates fuel the build-up of carry positions then it is questionable that raising interest rates can...


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