When Carry Trades in Currency Markets are not Profitable |
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Authors: | Richard T Baillie Dooyeon Cho |
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Institution: | 1. Departments of Economics and Finance, Michigan State University, , East Lansing, MI, 48824‐1024 USA;2. School of Economics and Finance, Queen Mary University of London, , UK;3. Rimini Center for Economic Analysis, , Italy;4. +82‐2‐910‐5617+82‐2‐910‐4519;5. Department of Economics, Kookmin University, , Seoul, 136‐702 Republic of Korea |
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Abstract: | The success of the carry trade in international currency and money markets is related to the extent of the forward premium anomaly. We present evidence that the anomaly is a very time dependent phenomenon. We also formulate a model where the ex post returns from the carry trade are functionally related to the relative difference between the interest rate on the funding currency and the interest rate associated with the target currency; i.e. the relative interest rate opportunity (RIRO). We estimate a nonlinear smooth transition regime model that relates the RIRO to the returns on the carry trade, and the estimated transition function then represents the time periods when the carry trade was profitable and when it was not. The analysis indicates that the desirability of carry trading has declined and for many currencies has actually become unprofitable since the financial crisis of 2008. |
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