Fluctuations in Exchange Rates and the Carry Trade
This paper examines the relationship between the carry trade and exchange rate volatility. In a carry trade, investors borrow in low-yield currencies and invest in high-yield currencies while bearing the exchange rate risk of depreciation that could undo this profit opportunity. Prior to the onset of the 2007 global financial crisis, the carry trade provided consistently high returns, later offset by large depreciations of high-yield currencies since. Thus, low exchange rate volatility prior to 2007 is often blamed for inducing investors to take on excessive carry trade risks. On the other hand, high levels of exchange rate volatility can be harmful because of currency mismatch – the well-known fear of floating. We investigate these issues by examining how volatility and the carry trade are related in the context of recent work by Brunnermeier, Nagel and Pedersen (2009) and Jordà and Taylor (2009).
Keywords: carry trade, exchange rates, foreign exchange market intervention JEL codes: F31, F37, F42, G15, G17