Swedroe: The Nuts & Bolts Of Currencies

February 13, 2017

The carry factor is the tendency for higher-yielding assets to provide higher returns than lower-yielding assets. A simplified description of the carry trade is the return an investor receives (net of financing) if an asset’s price remains the same.

The classic application is in currencies—the currency carry trade—which calls specifically for going long currencies of countries with the highest interest rates and shorting those with the lowest. Currency carry has been both a well-known and a profitable strategy for several decades. However, the carry trade is a general phenomenon, having been profitable across asset classes.

Ralph Koijen, Tobias Moskowitz, Lasse Pedersen and Evert Vrugt, authors of the 2013 study “Carry,” found that a carry trade going long high-carry assets and short low-carry assets earns significant returns in various asset classes with an annualized Sharpe ratio, on average, of 0.7.

For the period beginning in 1983 and ending in 2012, the authors found the currency carry trade produced an annual return of 5.3% with a Sharpe ratio of 0.68. It was also highly persistent, with the 1-, 3-, 5-, 10- and 20-year odds of producing a negative return being 25%, 12%, 6%, 2% and 0%, respectively.

However, they also found that individual carry strategies have excess kurtosis (fat tails) and exhibit sizable declines for extended periods of time coinciding with bad economic states, such as during recessions and in liquidity crises. This provides support for the theory that the excess return of the carry trade is compensation for bearing the risk that assets will perform poorly in bad times.

The carry trade is also investable, as the markets in which the carry trade invests are among the most liquid in the world. Thus, implementation costs are low. And carry has a simple, intuitive rationale arising from the long-established concept that prices balance out the supply and demand for capital across markets. High interest rates can signal an excess demand for capital not met by local savings while low rates suggest an excess supply.

The Puzzle Of UIP
According to traditional economic theory, in what is known as uncovered interest parity (UIP), there should be an equality of expected returns on otherwise-comparable financial assets that are denominated in two different currencies.

Rate differentials would be offset by currency appreciation or depreciation such that investor returns would be the same across markets. There is an overwhelming amount of empirical evidence, however, contradicting UIP theory, resulting in the UIP puzzle.

The UIP anomaly may be due to the presence of nonprofit-seeking market participants, such as central banks and corporate hedgers (companies who must convert currencies in order to conduct business abroad), introducing inefficiencies to currency markets and interest rates. The carry strategy is not without risk, as there can be instances when capital flees to low-yielding “safe havens.” As mentioned earlier, this provides a simple risk-based explanation for the carry premium in which positive performance over the long term is compensation for potential losses in bad economic environments.

In other words, currencies that appreciate when the stock market falls might be a good investment because they provide valuable insurance against unfavorable fluctuations in equity markets. On the other hand, currencies that depreciate in times of poor stock market performance tend to further destabilize investors’ positions, and should therefore offer a premium for that risk. With these concepts in mind, we’ll review the literature on the currency carry trade.

 

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