Discussion Note on the Currency Carry Trade
18 March 2014
The carry trade in currency markets means that an investor buys a high-yielding currency and finances this by borrowing money in a currency with a low interest rate. According to uncovered interest parity (UIP), the interest rate differential should equal the expected currency depreciation if investors are rational and risk-neutral. Under UIP, investors cannot benefit from differences in interest rates across countries. However, the empirical literature on the carry trade indicates that the average return from this strategy is positive and statistically and economically significant. There are, however, also prolonged periods of losses involved with the carry trade. These periods suggest that the carry trade is at least partially attributable to risk.
Due to their low correlation with equity and bond markets, carry strategies have historically improved the risk/return profile of equity and bond portfolios. During the burst of the tech bubble, the carry trade did not contribute to additional portfolio losses. However, the currency carry trade performed particularly poorly during the Lehman crisis, leading to investor losses above 20 percent. During the same period, prices of most risky assets declined, which has sparked the debate on risk-based explanations of currency carry trade returns. Risk-based explanations include exposure to liquidity risks, volatility risk, downside, crash or rare event risks, currency convertibility risks, trade balance risks, or time-varying risks with regard to stock and bond markets.