Why Are Carry Traders Profiting?

As we have discussed, one of the more popular strategies of hedge funds and speculators is the currency carry trade. The strategy involves borrowing a currency with a relatively low interest rate and using the proceeds to purchase a currency yielding a higher interest rate, capturing the interest differential. The strategy can be "enhanced" though the use of leverage.

The currency carry trade presents a problem. Investors should figure on expected returns of similar assets to be equal, even if they're denominated in different currencies. However, the currency carry trade has provided returns outside of what one would expect.

Because of its popularity and potential, the carry trade has become one of the most studied areas of modern finance. Among the recent papers contributing to our understanding of the carry trade is the May 2011 paper, "Common Risk Factors in Currency Markets." The authors studied the period from 1999 through 2009 and covered 35 currencies, including both developed and emerging market countries where forward contracts were easily accessible.

To compute returns net of bid-ask spreads, the authors assumed that investors shorted the low-yield foreign currencies and went long the high-yield currencies. After expenses, the net returns of the two portfolios was in excess of 4.5 percent. And the results are statistically significant. The authors also found that the premium is related to changes in global equity market volatility -- high (low) interest rate currencies tend to depreciate (appreciate) when global equity volatility is high. They concluded that the price of volatility is negative (and statistically significant). In other words, by investing in high-interest-rate currencies and borrowing low-interest-rate currencies, U.S. investors are loading up on global risk.

Other studies have found similar results. For example, the 2009 study, "Carry Trade and Global Foreign Exchange Volatility," found that more than 90 percent of the cross-sectional excess returns from the carry trade was explained by foreign exchange volatility -- providing further evidence that the excess return is a result of an economically meaningful risk-return relationship. In times of heightened volatility, lower-interest-rate currencies offer insurance, because their exchange rate appreciates in response to an adverse global shock. Thus, these "safe havens" (such as the Swiss franc and Japanese yen) earn a lower risk premium than others perceived as more risky. Safe-haven currencies tend to appreciate when market risk and illiquidity increase.

Most investors are risk averse. In particular, they dislike assets that tend to perform poorly during risky times. They also care about whether the distribution of returns is normal (shaped like a bell curve). In particular, they dislike assets whose distribution of returns exhibit negative skewness and excess kurtosis (fat tails). These attributes present the potential for large losses. The evidence suggests that the currency carry trade has these characteristics.

The negative skewness and excess kurtosis result from the carry trade's exposure to the stock market and bond markets. The result is that risks to the strategy increase at the wrong time, when there are increases in the volatility of markets. And investors demand large premiums to bear such risks.

Photo courtesy of bradipo on Flickr.
More on MoneyWatch:
Borrowing Low-Yielding Currencies to Buy High-Yielding Currencies Works, Until It Doesn't Momentum Loses Its Momentum 5 Things You Should Consider Before Buying Municipal Bonds Warren Buffett's Math Lesson TIPS Update for October 2011
Three ways I can help you become a wiser investor:

• Follow me on Twitter: http://twitter.com/larryswedroe.
• Preorder my next book Investment Mistakes Even Smart Investors Make and How to Avoid Them.
• Download the podcast of my radio show via Buckingham Asset Management's iTunes page.