An Empirical Analysis of Currency Carry Trade Strategies
AN EMPIRICAL STUDY OF CURRENCY CARRY TRADE STRATEGIES
1
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
2
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
1
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
2
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
Bibliography: Arellano, M. (1987), “PRACTITIONERS’ CORNER: Computing Robust Standard Errors for Within-groups Estimators.” Oxford Bulletin of Economics and Statistics, 49: 431–434. Backus, D. K., S. Foresi, and C. I. Telmer (2001), “Affine Term Structure Models and the Forward Premium Anomaly”. Journal of Finance 56: 279–304. Bekaert, G. (1996), “The Time-variation of Expected Returns and Volatility in Foreignexchange Markets: A General Equilibrium Perspective”. Review of Financial Studies 9: 42770. Béranger, F, G Galati, K Tsatsaronis and K von Kleist (1999): “The yen carry trade and recent foreign exchange market volatility”, BIS Quarterly Review, March, pp 33–7. Bhargava, Alok (1986) "On the Theory of Testing for Unit Roots in Observed Time Series," Review of Economic Studies, 53, 369–384. Breedon, Francis (2001) “Market Liquidity under Strees: Observations in the FX Market”, http://www.bis.org/publ/bppdf/bispap02g.pdf Brunnermeier, M K, Nagel, S and Pedersen, L H, Carry Trades and Currency Crashes, (April 2009), NBER Macroeconomics Annual 2008, Volume 23 Burnside, C, M Eichenbaum, I Kleshehelski and S Rebelo (2006): “The returns to currency speculation”, NBER Working Papers, no 12489, August. Burnside, C, M Eichenbaum and S Rebelo (2007): “The returns to currency speculation in emerging markets”, AEA Papers and Proceedings, vol. 97(2), pp 333–8. Burnside, C, M Eichenbaum, I Kleshchelski and S Rebelo (2011): “Do Peso Problems Explain the Returns to the Carry Trade?”, The Review of Financial Studies (2011) 24 (3): 853-891. Cairns, J, C Ho and R McCauley (2007): “Exchange rates and global volatility: implications for Asia-Pacific currencies”, BIS Quarterly Review, March, pp 41–52. Darvas, Zs. (2008), “Leveraged Carry Trade Portfolios”, Journal of Banking and Finance, Volume 33, Issue 5, May 2009, Pages 944-957 Farhi, E and Gabaix, X, “Rare disasters and Exchange Rates”, (February 2008), NBER Working Paper No. 13805 Friedman, Milton (1953), Essays in Positive Economics, Chicago University Press International Monetary Fund (1998): World economic outlook: financial turbulence and the world economy, October. Jonsson, Asgeir (2009), “Why Iceland?”, McGraw-Hill, New York 31 Kamil, Herman, Is Central Bank Intervention Effective Under Inflation Targeting Regimes? The Case of Colombia (April 2008). IMF Working Papers, Vol. , pp. 1-42, 2008. Kwiatkowski, Phillips, Schmidt, and Shin (1992): Testing the Null Hypothesis of Stationarity against the Alternative of a Unit Root. Journal of Econometrics 54, 159–178. MacKinnon, J. G. (1996), “Numerical distribution functions for unit root and cointegration tests”, Journal of Applied Econometrics, 11, 601 608. Merrill Lynch (2007): “CDOs go beyond credit: FX CDOs, CCOs, EDS and CDOs”, European Structured Finance, CDO, March 2007. Moutot, P and Vitale, G, (2009) „Monetary Policy Strategy in a Global Environment” ECB Occasional Paper 106, http://www.ecb.int/pub/pdf/scpops/ecbocp106.pdf Newey, Whitney K. and Kenneth D. West (1994). “Automatic Lag Length Selection in Covariance Matrix Estimation,” Review of Economic Studies, 61, 631-653. Plantin, Guillaume and Shin, Hyun Song, Carry Trades, Monetary Policy and Speculative Dynamics (February 2011). CEPR Discussion Paper No. DP8224. Roubini, Nouriel, “Mother of all carry trades faces an inevitable bust.” Financial Times November 1, 2009. Taleb, Nassim Nicholas, ”Black Swans and the Domains of Statistics.” The American Statistician. August 1, 2007, 61(3): 198-200. Wooldridge, Jeffrey M. “Econometric analysis of cross section and panel data.” Cambridge, MA: MIT Pres 32