Commodity Trade and the Carry Trade: A Tale of Two Countries

• DOI: http://doi.org/10.1111/jofi.12546
• Published date: 01 December 2017
• Date: 01 December 2017

THE JOURNAL OF FINANCE •VOL. LXXII, NO. 6 •DECEMBER 2017

Commodity Trade and the Carry Trade:

A Tale of Two Countries

ROBERT READY, NIKOLAI ROUSSANOV, and COLIN WARD∗

ABSTRACT

Persistent interest rate differentials account for much of the currency carry trade

profitability.“Commodity currencies” offer high interest rates on average, while coun-

tries that export finished goods tend to have low interest rates. We develop a general

equilibrium model of international trade and currency pricing where countries have

an advantage in producing either basic inputs or final goods. In the model, domestic

production insulates commodity-producing countries from global productivity shocks,

forcing final-good producers to absorb them. Commodity-currency exchange rates and

risk premia increase with productivity differentials and trade frictions. These predic-

tions are strongly supported in the data.

ACURRENCY CARRY TRADE IS A STRATEGY THAT GOES long high interest rate

currencies and short low interest rate currencies. A typical carry trade in-

volves buying the Australian dollar, which over much of the last three decades

earned a high interest rate, and funding the position with borrowing in the

Japanese yen and thus paying an extremely low rate on the short leg. Such

a strategy earns positive expected returns on average, and exhibits high

∗Robert Ready is with the Lundquist College of Business at the University of Oregon. Nikolai

Roussanov is with the Wharton School at the University of Pennsylvania and the NBER. Colin

Ward is with the Carlson School of Management at the University of Minnesota. We benefited

from comments by Andy Abel, Rui Albuquerque, Dave Backus, Gurdip Bakshi, John Campbell,

Hui Chen, Mike Chernov,Ric Colacito, Max Croce, Darrell Duffie, Bernard Dumas, Amora Elsaify,

Xavier Gabaix, Jeremy Graveline, Robin Greenwood, Lars Hansen, Tarek Hassan, Burton Holli-

field, Urban Jermann, Karen Lewis, Debbie Lucas, Hanno Lustig, Don Keim, Brent Neiman, Anna

Pavlova, Bryan Routledge, Jose Scheinkman, Ivan Shaliastovich, Ken Singleton, Rob Stambaugh,

Andreas Stathopoulos, Sheridan Titman, Adrien Verdelhan, Jessica Wachter, Amir Yaron, Stan

Zin, and audiences at the AFA and ASSA/IEFS meetings, AQR, CEPR ESSFM Gerzensee, Duke

ERID macrofinance conference, Erasmus University Rotterdam, Goethe University Frankfurt,

Minnesota Asset Pricing conference, INSEAD, Macro-Financial Modeling Workshop, NBER SI,

NBIM, Notre Dame, Oxford-MAN Currency Trading conference, SECOR, SED, Stockholm School

of Economics, Temple, Texas Finance Festival, Utah Winter Finance Conference, WFA, and Whar-

ton. Roussanov acknowledges financial support from the Iwanowski Family Research Fellowship

and Wharton Global Research Initiative. The authors have read the Journal of Finance’s disclosure

policy and have no conflicts of interest to disclose. The paper was awarded the AQR Insight Award

in April 2015 as a cowinner of the academic competition. Each of the coauthors was awarded a

monetary prize of over $10,000. However, no author has any responsibilities toward AQR Capital

Management or any of its affiliates.

DOI: 10.1111/jofi.12546

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2630 The Journal of Finance R

Sharpe ratios despite its substantial volatility. In the absence of arbitrage,

such patterns imply that the marginal utility of an investor whose consump-

tion basket is denominated in yen is more volatile than that of an Australian

consumer and faces greater exposure to global sources of risk (as shown in

Lustig, Roussanov, and Verdelhan (2011)). Are there fundamental economic

differences between countries that could give rise to such heterogeneity in

risk?

One source of differences across countries is the composition of their trade.

Countries that specialize in exporting basic commodities, such as Australia

or New Zealand, tend to have high interest rates. Conversely, countries that

import most of their basic input goods and export finished consumption goods,

such as Japan or Switzerland, have low interest rates on average. These dif-

ferences in interest rates do not translate into depreciation of “commodity

currencies” on average; rather, they constitute positive average returns, which

gives rise to a carry-trade-type strategy. In this paper, we develop a theo-

retical model of this phenomenon, document that this empirical pattern is

systematic and robust over the recent time period, and provide additional ev-

idence in support of the model’s predictions for the dynamics of carry trade

strategies.

Our model features two spatially segmented countries that differ in their en-

dowments and technologies. The “commodity” country uses local resources to

produce a basic good that is an intermediate input into the production of a con-

sumable final good, as well as the final good itself. The “producer” country can

only produce the final good but is more efficient at doing so than the commodity

country. Finally, there is a friction in the goods markets in the form of costly

trade in the final good, while financial markets are complete.1Therefore, in

equilibrium countries specialize, but not completely—the commodity country

will produce some of the final good as long as doing so is cheaper than import-

ing it from abroad. The real exchange rate reflects the magnitude of this trade

friction, and is equal to the relative price of the basic commodity in the two

countries in terms of the numeraire consumption good. As a result, it is closely

tied to the relative productivity of the two countries’ final good sectors. When

the productivity wedge widens, the “world” price of the commodity is higher

relative to the “local” price in the commodity country, and hence the commod-

ity currency appreciates. As producer country’s productivity dominates global

business cycle fluctuations, this implies that the commodity currency appreci-

ates in “good” times and depreciates in “bad” times. Therefore, the commodity

currency is risky and earns a risk premium.

This commodity-currency risk premium stems from the fact that commodity-

currency consumption is relatively insulated from (global) productivity shocks:

a relative decline in producer-country productivity reduces global output, but

since the commodity country can shift local resources into producing the final

1Trade costs have a long tradition in international finance, for example, in Dumas (1992)and

Hollifield and Uppal (1997). Obstfeld and Rogoff (2001) argue that trade costs are key to resolving

several major puzzles in international economics.

Commodity Trade and the Carry Trade 2631

good domestically, its consumption declines by less than that of the producer

country. Consequently, marginal utility of consumption rises more in the pro-

ducer country.This difference in exposure also leads to a stronger precautionary

motive for saving in the producer country so that, all else equal, the producer

country has a lower interest rate. Thus, the commodity-currency risk premium

manifests itself as a carry trade: the risky commodity currency earns a higher

interest rate. Both the risk premium and the interest rate differential increase

in the relative productivity wedge, which is also reflected in the magnitude of

net imports of the final good plus net exports of the commodity, relative to a

country’s output of the final good.

We show empirically that sorting currencies into portfolios based on net

imports of finished (manufactured) goods and net exports of basic commodi-

ties generates a substantial spread in both interest rates and average excess

returns. It largely subsumes the cross-sectional carry trade documented by

Lustig, Roussanov,and Verdelhan (2011) in our sample of advanced economies.

Further, we show that final-good producing countries are substantially more

exposed to global output shocks, which makes commodity countries relatively

less risky, as our model predicts. Crucially, relative productivity differentials

between commodity countries and their main trading partners among the final

good producers are very closely related to the corresponding real exchange rate

movements and real interest rate differentials.

The model makes a number of additional predictions that are consistent

with salient features of the data. Commodity-currency carry trade returns

are positively correlated with commodity price changes, both in the model

and in the data (we provide evidence using an aggregate commodity index,

which complements the result in Ferraro, Rossi, and Rogoff (2011) based on

individual currency and commodity price data). Moreover, the model predicts

that conditional expected returns on the commodity-currency carry trade are

especially high when global goods markets are most segmented, that is, when

trade costs are particularly high. We show that a popular measure of shipping

costs, namely, the Baltic Dry Index (BDI), forecasts carry trade returns. Our

model also rationalizes evidence documented by Bakshi and Panayotov (2013)

of carry trade predictability with a commodity price index, since commodity

prices are typically high in the model during booms, when trade costs are also

high.

The fact that carry trade strategies typically earn positive average returns

is a manifestation of the failure of the uncovered interest parity (UIP) hy-

pothesis, a major longstanding puzzle in international finance. A longstanding

consensus in the international finance literature attributed all of carry trade

average returns to conditional risk premia, finding little evidence of nonzero

unconditional risk premia on individual currencies throughout most of the 20th

century (e.g., Lewis (1995)). Consequently, much of the literature has focused

on explaining conditional currency risk premia by ruling out asymmetries (e.g.,

Verdelhan (2010), Bansal and Shaliastovich (2012), Colacito and Croce (2013)).

However, Lustig, Roussanov, and Verdelhan (2011) show that unconditional

currency risk premia are, in fact, substantial and Hassan and Mano (2014)