Macroeconomic Determinants of Carry Trade Activity

Abstract:     
Carry trades - a popular strategy in the foreign exchange market - are long positions in high interest rate currencies financed by borrowing low interest rate currencies. Such positions are held as long as i) there remains a significant interest rate differential between the two currency groups and/or ii) exchange rate risk remains low. When either or both such conditions are violated positions are typically unwound, triggering rapid movements in the exchange rate level and its volatility and spillovers to other asset classes as well as to real activity. The recent global deleveraging has clearly evidenced the strength of this channel. From a financial standpoint, the mechanics of the carry trade has been recently examined in Brunnermeier et al. (2009). They showed that shocks to interest rate differentials lead to carry trade activity and to significant reactions in the bilateral exchange rates vis-a-vis the US dollar that they analyse. Starting from their paper, we take a more macroeconomic standpoint and aim to identify what kind of structural shock can generate the implications of their interest rate differential shock. To this aim we add two macroeconomic variables and two indicators of confidence to the 4-variable financial VAR of Brunnermeier et al. (2009) and use sign restrictions on the impulse responses of the resulting larger VAR to identify four macroeconomic shocks. We evidence that although all shocks may potentially have effects on developments in the interest rate differential and the exchange rate level that overall make carry trading profitable in the short run, demand shocks and confidence shocks only are associated with longer-term gains from carry trade activity, relative to supply and monetary policy shocks. This finding also supports the widely reported idea that sentiment boosts position taking. We also provide a measure of the potential gain/losses experienced by the actual positioning of market participants in the foreign exchange futures market, conditional on their ability to correctly anticipate the nature of the prevailing macroeconomic shock.

Number of Pages in PDF File: 42

Keywords: Carry Trade, Speculative Activity, Sign Restriction

JEL Classification: G12, G14, G15

working papers series