Carry Trades and Speculative Dynamics

39 Pages Posted: 26 Apr 2006

See all articles by Guillaume Plantin

Guillaume Plantin

University of Toulouse 1 - Toulouse School of Economics (TSE)

Hyun Song Shin

Bank for International Settlements (BIS)

Date Written: March 2006

Abstract

When a currency trader borrows Japanese yen at 1 percent to fund the purchase of US dollar assets that yield 5 percent, the trader makes a profit even if the dollar/yen exchange rate remains unchanged. This paper examines the implications of such carry trades for speculative dynamics. In the absence of carry costs, we establish the benchmark result that speculation can be ruled out. However, carry costs can drastically change the nature of the price dynamics. Our results suggest that markets that combine significant costs of carry and low "resiliency" (such as the foreign exchange market) have the pre-conditions for large and persistent deviations of price from fundamentals, followed by abrupt reversals. Not only does uncovered interest parity fail, but a currency with a high interest rate will exhibit the classic price pattern of going up by the stairs, and coming down in the elevator.

Keywords: Carry Trades, Exchange Rates, Speculation

JEL Classification: F31, G12

Suggested Citation

Plantin, Guillaume and Shin, Hyun Song, Carry Trades and Speculative Dynamics (March 2006). Available at SSRN: https://ssrn.com/abstract=898412 or http://dx.doi.org/10.2139/ssrn.898412

Guillaume Plantin

University of Toulouse 1 - Toulouse School of Economics (TSE) ( email )

Place Anatole-France
Toulouse Cedex, F-31042
France

Hyun Song Shin (Contact Author)

Bank for International Settlements (BIS) ( email )

Centralbahnplatz 2
Basel, Basel-Stadt 4002
Switzerland

HOME PAGE: http://www.bis.org/author/hyun_song_shin.htm

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