Carry Trades and Speculative Dynamics
39 Pages Posted: 26 Apr 2006
Date Written: March 2006
Abstract
When a currency trader borrows Japanese yen at 1 percent to fund the purchase of US dollar assets that yield 5 percent, the trader makes a profit even if the dollar/yen exchange rate remains unchanged. This paper examines the implications of such carry trades for speculative dynamics. In the absence of carry costs, we establish the benchmark result that speculation can be ruled out. However, carry costs can drastically change the nature of the price dynamics. Our results suggest that markets that combine significant costs of carry and low "resiliency" (such as the foreign exchange market) have the pre-conditions for large and persistent deviations of price from fundamentals, followed by abrupt reversals. Not only does uncovered interest parity fail, but a currency with a high interest rate will exhibit the classic price pattern of going up by the stairs, and coming down in the elevator.
Keywords: Carry Trades, Exchange Rates, Speculation
JEL Classification: F31, G12
Suggested Citation: Suggested Citation
Do you have negative results from your research you’d like to share?
Recommended Papers
-
The Forward Discount Anomaly and the Risk Premium: A Survey of Recent Evidence
-
The Cross-Section of Foreign Currency Risk Premia and Consumption Growth Risk
By Hanno N. Lustig and Adrien Verdelhan
-
The Cross-Section of Foreign Currency Risk Premia and Consumption Growth Risk
By Hanno N. Lustig and Adrien Verdelhan
-
The Returns to Currency Speculation
By A. Craig Burnside, Martin Eichenbaum, ...
-
The Returns to Currency Speculation
By A. Craig Burnside, Martin Eichenbaum, ...
-
The Cross-Section of Currency Risk Premia and Us Consumption Growth Risk
By Hanno N. Lustig and Adrien Verdelhan
-
The Cross-Section of Foreign Currency Risk Premia and Consumption Growth Risk: A Reply
By Hanno N. Lustig and Adrien Verdelhan
-
The Cross-Section of Foreign Currency Risk Premia and Consumption Growth Risk: A Reply
By Hanno N. Lustig and Adrien Verdelhan
-
Carry Trades and Currency Crashes
By Markus K. Brunnermeier, Stefan Nagel, ...