Speculative Capital and Currency Carry Trades

Abstract

In this paper, we study a two-country general equilibrium model with partially segmented financial markets, where hedge funds emerge endogenously. Empirically, we show that the hedge fund investment strategy predicted by our model, so called “risk-adjusted carry trade” strategy, explains more than 16% of a broad hedge fund index returns and more than 33% of a fixed income arbitrage sub-index returns. The flow of new money to hedge funds affects market interest rates, exchange rate, the both the hedge fund’s contemporaneous and expected future returns as predicted by the model.

Keywords: Hedge funds, carry trades, currency speculation

JEL Classification: F31, G15, E43