When Carry Trades in Currency Markets are not Profitable

• Author: Richard T. Baillie,Dooyeon Cho
• DOI: http://doi.org/10.1111/rode.12119
• Date: 01 November 2014
• Published date: 01 November 2014

When Carry Trades in Currency Markets are

not Profitable

Richard T. Baillie and Dooyeon Cho*

Abstract

The success of the carry trade in international currency and money markets is related to the extent of the

forward premium anomaly. We present evidence that the anomaly is a very time dependent phenomenon.

We also formulate a model where the ex post returns from the carry trade are functionally related to the

relative difference between the interest rate on the funding currency and the interest rate associated with

the target currency; i.e. the relative interest rate opportunity (RIRO). We estimate a nonlinear smooth

transition regime model that relates the RIRO to the returns on the carry trade, and the estimated transi-

tion function then represents the time periods when the carry trade was profitable and when it was not. The

analysis indicates that the desirability of carry trading has declined and for many currencies has actually

become unprofitable since the financial crisis of 2008.

1. Introduction

The existence of the carry trade is now a well documented phenomenon, where an

investor borrows in a currency associated with a low interest rate country, which is

known as a funding currency and then invests in a higher yielding, or target currency.1

Carry trades are now considered to be one of the main motivations for currency

trading. The intriguing aspect of the carry trade phenomenon is that agents are essen-

tially engaged in short run positions and attempting to make quick profits before the

high interest rate currency, that they have invested in, suffers a depreciation as

expected from uncovered interest rate parity (UIP). Hence the agents are speculating

on the violation of UIP, or the existence of the forward premium anomaly.

Since Froot and Thaler (1990) it has become fashionable to assume the forward

premium as an unchanging stylized fact in international finance. However, this is not

always the case, and we show evidence in this paper of substantial time variation in

both the existence and magnitude of the forward premium anomaly in many of the

major currencies vis-à-vis the US dollar. The time varying slope coefficients show dra-

matic variation across time over the last 30 years. This has implications for the profit-

ability or otherwise of the carry trade strategy. In particular, the financial crisis of

2008 has apparently led to a reversal of the anomaly for many currencies and the

apparent collapse of a profit from carry trades for some currencies. We then formu-

late a hypothesis that the ex post returns from the carry trade are functionally related

* Baillie: Departments of Economics and Finance, Michigan State University, East Lansing, MI 48824-

1024, USA; Tel: +1-517-355-1864; Fax: +1-517-432-1068; E-mail: baillie@msu.edu. Also affiliated to School

of Economics and Finance, Queen Mary University of London, UK and Rimini Center for Economic

Analysis, Italy. Cho: Department of Economics, Kookmin University, Seoul 136-702, Republic of Korea;

Tel: +82-2-910-5617; Fax: +82-2-910-4519; E-mail: dcho@kookmin.ac.kr. The authors are grateful to an

anonymous referee, and seminar participants at Yonsei University, the Society for Nonlinear Dynamics

and Econometrics 19th Annual Symposium, 2012 Korea International Economic Association Winter Con-

ference, and 2013 Korean Econometric Society Summer Conference for their helpful comments. All

remaining errors are the authors’ responsibility.

Review of Development Economics, 18(4), 794–803, 2014

DOI:10.1111/rode.12119

© 2014 John Wiley & Sons Ltd