Researchers at the University of California have found that the carry-trade, whereby money is borrowed in low-yielding currencies in order to buy high-yielding ones, has actually been a pretty effective source of stable returns for those willing to do it.
Which is peculiar given that, if it’s such a good deal, one would expect the market to arbitrage away these returns as more and more investors piled in.
Yet beyond these researchers’ conclusion that the carry trade has been relatively successful, they also took their analysis a step further. They claim to have a model whereby the carry trade yields even more stable returns over time — by simply avoiding the large losses that can happen from time to time.
Even if you aren’t convinced that this research could play out as well in the real world, which is usually the case, such thinking shows how the carry trade won’t go away any time soon. So don’t fight it, ride it.
The Economist: The authors first examine returns to a simple carry trade for a set of 10 rich-country currencies between 1986 and 2008. Buying the highest yielder of any currency pair produced an average return of 26 basis points (hundredths of a percentage point) per month. That would be fine, except that the standard deviation of returns, a gauge of how variable profits are, was almost 300 basis points. The monthly Sharpe ratio that measures returns against risk was a “truly awful” 0.1 (the higher the ratio, the better the risk-adjusted performance). Worse still, the distribution of monthly profits was negatively skewed: big losses were more likely to occur than windfall gains.
No sane trader would follow a rule with such poor results. So the authors put together a far richer model to help decide which side of a currency trade to be on. It included things that are most likely to influence short-term movements in currencies, such as the change in the exchange rate over the previous month, as well as the size of the interest-rate and inflation gap between each currency. They found that all three factors mattered. Currencies that rose in one month tended to rise in the next month. Those with the highest interest rates went up most, as did currencies with high inflation (which drives expectations of further rate rises).
These impulses can drive exchange rates a long way from their fair or “equilibrium” values. That creates the risk of a sudden reversion that could wipe out earlier profits. To guard against this, the authors added to their model a measure of how far the exchange rate has shifted from its fair value. They found that this alarm bell can sometimes turn a “buy” signal into a “sell”.