Carry trades are a significant part of the $5 trillion that is traded on the foreign exchange markets every day. Inflation rate differentials notwithstanding, carry trades do have short-term potential.
How Is This Article Useful to Practitioners?
On a daily basis, foreign exchange transactions amount to $5 trillion, whereas global trade in goods and services averages $50 billion a day. Shifting capital around the world is thus a much greater force when it comes to moving currencies than is the sale of goods and services.
The carry trade, which involves borrowing money in a country with low interest rates and investing the proceeds in countries with higher interest rates, is one of the larger contributors to the daily movement of currency. Purchasing power parity (PPP) indicates that the interest rate differential between currencies is offset by the inflation differential, so there should be no gain from these types of trades. But a review of 33 years of data for five currencies reveals that although PPP holds up in the long run, in the short run there is an opportunity to make a profit from the interest differential. The currency of the country with a higher exchange rate tends to outperform the forward exchange rate slightly more often than not. In addition, countries with a persistent current account deficit have a greater need for foreign currency, which is reflected in the value of their currency. Overall, carry trades, although simple in nature, provide traders with a short-term, risk-free profit.
Abstractor’s Viewpoint
The author highlights that it is not always the complex structures that offer profitable opportunities. Such simple, unexciting transactions as carry trades can provide a steady income.