Swedroe: The Perils Of The Carry Trade

March 13, 2014

The so-called carry trade does have its allure, but its risks may be underappreciated, Swedroe argues.

What's known as the carry trade is one of the more popular strategies of hedge funds, and it's also becoming popular for investors seeking alternative fixed-income strategies that can provide higher yields in today's environment of low rates.

The strategy involves borrowing (going short) a currency with a relatively low interest rate and using the proceeds to purchase (going long) a currency yielding a higher interest rate, capturing the interest differential. The strategy can be "enhanced" through the use of leverage.

The papers "The Time-Varying Systematic Risk of Carry Trade Strategies" and "Carry Trades, Momentum Trading and the Forward Premium Anomaly" reached the same conclusions.

  • The carry trade strategy has been quite successful.
  • The carry trade experiences what can be called crashes—they come with the risk of large losses (so-called fat tails) that tend to occur at the same time that equity markets are crashing.

The authors of the 2013 paper, "Carry" took another look at the subject of the carry trade. They noted: "The concept of 'carry' has been applied almost exclusively to currencies, where it simply represents the interest differential between two countries. However, carry is a more general phenomenon that can be applied to any asset. Put simply, we define carry as the expected return on an asset assuming its price does not change."

(In other words, assuming stock prices don't change; currency yields don't change; bond yields don't change; and spot commodity prices remain unchanged).

To put a finer point on it, this means:

  • For equities, the carry trade is defined by the dividend yield—the strategy is going long countries with high dividend yield and short currencies with low dividend yield
  • For bonds, by the term structure of rates
  • For commodities, by the roll return—the difference between spot rates and future rates.

The time periods used varied based on availability but were at least 20 years. Their findings confirm the result found in prior research on the subject. The following is a summary of their conclusions:

 

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