Arbitrage Capital and Currency Carry Trade Returns

Abstract

We develop a model based on risk averse investors and limited arbitrage capital to explain the rationale for the so called carry trades: that is, trades where "the purchase of riskier, higher-yielding assets is funded by selling lower-yielding currencies" (Financial Times, January 28, 2008). In our model, due to partially segmented markets and differences in inflation risk and money supply, the returns to carry trades are positive, but decrease in the amount of arbitrage capital. In the empirical part of the paper, using 32 years of exchange rate data, we document several new results related to carry trades and provide empirical support for the model's predictions. We empirically document that 1) carry trade returns explain a significant part of hedge fund index returns, providing strong evidence that carry trades are indeed used by arbitrageurs, 2) the positive returns to carry trades have been decreasing over time in parallel with an increase in arbitrage capital, 3) the real interest rates are higher in countries with higher inflation risk and higher per capita money supply, but higher arbitrageurs' equity capital and a better funding liquidity for them decrease the cross country differences in real interest rates, 4) flow of new arbitrage capital leads to an appreciation (depreciation) of the carry long (short) currencies.At the time of the paper, there is an ongoing large outflow of arbitrage capital from hedge funds, and this has been associated with a large appreciation of Japanese yen, US dollar and Swiss franc and a large depreciation of euro, Canadian dollar and British pound, in relation to most other currencies. These currency movements are consistent with our results, as at the time of the paper yen, US dollar and Swiss franc are carry trade short currencies and euro, Canadian dollar and British pound are carry trade long currencies.

Detecting Crowded Trades in Currency Funds

“…While the popular press attributes the liquidation of the carry trade to the credit crunch and the decline of the equity markets, a possible reason behind the rapid liquidation of carry trades might be that this strategy had become crowded. This result is consistent with the "liquidity spiral" story suggested by Pedersen (2009) and the shrinking hedge fund asset base discussed in Jylhä and Suominen (2009).…”

“…Alternatively, each manager could be weighted by their assets under management (AUM). In a related paper,Jylhä and Suominen (2009) find that AUM at hedge funds are significantly related to contemporaneous and expedited future returns from a risk-adjusted carry trade. Unfortunately, we do not have data on AUM for the managers in our sample to experiment with this alternative measure.…”

Carry Trades and Currency Crashes

“…Burnside (2007) argues, however, that their model leaves unexplained a highly significant excess zero-beta rate (i.e., intercept term), and Burnside et al (2006) find that the return of the carry trade portfolio is uncorrelated to standard risk factors, attributing instead the forward premium to market frictions (bid-ask spreads, price pressure, and time-varying adverse selection in Burnside, Eichenbaum, and Rebelo [2007]). Jylhä, Lyytinen, and Suominen (2008) argue that inflation risk is higher in high interest rate currencies and show a positive relationship between carry trade returns and hedge fund indices.…”

Tobin in Europe: A Case for the Financial Transaction Tax

“…That it does not always work that way can be seen with the example of the so-called carry trades that stand in sharp contrast to exchange rate theory. By definition arbitrage is risk-free, whereas carry trades always involve risk (Jylhä, Suominen, & Lyytinen, 2008). For a carry trade money is borrowed in a market with low interest rates and invested in a market with high interest rates with the expectation that the exchange rate in the first market appreciates.…”