What Explains the Carry Trade?
Over much of the 2000s, Japanese yen interest rates were close to zero (as Figure 14-2 shows) while Australia’s interest rates were comfortably positive, climbing to over 7 percent per year by the spring of 2008. While it might therefore have appeared attractive to borrow yen and invest the proceeds in Australian dollar bonds, the interest parity condition implies that such a strategy should not be systematically profitable: On average, shouldn’t the interest advantage of Australian dollars be wiped out by relative appreciation of the yen?
Nonetheless, market actors ranging from Japanese housewives to sophisticated hedge funds did in fact pursue this strategy, investing billions in Australian dollars and driving that currency’s value up, rather than down, against the yen. More generally, international investors frequently borrow low-interest currencies (called “funding” currencies) and buy high-interest currencies (called “investment” currencies), with results that can be profitable over long periods. This activity is called the carry trade, and while it is generally impossible to document the extent of carry trade positions accurately, they can become very large when sizable international interest differentials open up. Is the prevalence of the carry trade evidence that interest parity is wrong?
The honest answer is that while interest parity does not hold exactly in practice— in part because of the risk and liquidity factors mentioned above—economists are still working hard to understand if the carry trade requires additional explanation. Their work is likely to throw further light on the functioning of foreign exchange markets in particular and financial markets in general.
One important hazard of the carry trade is that investment currencies (the high-interest currencies that carry traders target) may experience abrupt crashes. Figure 14-7 illustrates this feature of foreign exchange markets, comparing the cumulative return to investing ¥100 in yen bonds and in Australian dollar bonds over different investment horizons, with the initial investment being made in the final quarter of 2002. As you can see, the yen investment yields next to nothing, whereas Australian dollars pay off handsomely, not only because of a high interest rate but because the yen tended to fall against the Australian dollar through the summer of 2008. But in 2008, the Australian dollar crashed against the yen, falling in price from ¥104 to only ¥61 between July and December. As Figure 14-7 shows, this crash did not wipe out the gains to the carry trade strategy entirely—if the strategy had been initiated early enough! Of course, anyone who got into the business late, for example, in 2007, did very poorly indeed. Conversely, anyone savvy enough to unwind the strategy in June 2008 would have doubled his or her money in five and a half years. The carry trade is obviously a very risky business.
We can gain some insight into this pattern by imagining that investors expect a gradual 1 percent annual appreciation of the Australian dollar to occur with high probability (say, 90 percent) and a big 40 percent depreciation to occur with a 10 percent probability. Then the expected appreciation rate of the Australian dollar is:
The negative expected appreciation rate means that the yen is actually expected to appreciate on average against the Australian dollar. Moreover, the probability of a crash occurring in the first six years of the investment is only 1 – (0.9)6
= 1 - 0.53 = 47 percent, less than fifty-fifty.9 The resulting pattern of cumulative returns could easily look much like the one shown in Figure 14-7. Calculations like these are suggestive,
and although they are unlikely to explain the full magnitude of carry trade returns, researchers have found that investment currencies are particularly subject to abrupt crashes, and funding currencies to abrupt appreciations.10
Complementary explanations based on risk and liquidity considerations have also been advanced. Often, abrupt currency movements occur during financial crises, which are situations in which other wealth is being lost and liquid cash is particularly valuable. In such circumstances, large losses on carry trade positions are extra painful and may force traders to sell other assets they own at a loss.11
We will say much more about crises in later chapters, but we note for now that the Australian dollar collapse of late 2008 occurred in the midst of a severe global financial crisis.
When big carry trade positions emerge, the government officials responsible for international economic policies often lose sleep. In their early phase, carry trade dynamics will drive investment currencies higher as investors pile in and build up ever-larger exposures to a sudden depreciation of the investment currency. This makes the crash bigger when it occurs, as wrong-footed investors all scramble to repay their funding loans. The result is greater exchange rate volatility in general, as well as the possibility of big trader losses with negative repercussions in stock markets, bond markets, and markets for interbank loans.