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The ‘carry’ trade

The carry strategy in foreign exchange markets generates positive average returns over the long run, but it can experience losses when there are shifts from fixed to floating currency regimes, finds a new study co-authored by Dr David Chambers of Cambridge Judge Business School.

Footbridge and Modern office buildings in central Hong Kong at night

The “carry” trade in foreign exchange markets – buying currencies with high-interest rates and selling low-interest-rate currencies – is a simple and popular strategy and has been shown to be profitable in a wide range of academic studies of currency markets using data from the 1980s. One important question is how robust this result is if we study a much longer time period.

A new paper published in the Journal of Financial and Quantitative Analysis finds that when looking at currency markets over an entire century, the carry trade remains profitable even after transaction costs. However, the study also strikes a note of caution in that the carry trade can be very risky. This is not only because there are periods when the strategy experiences sizeable losses or “drawdowns” – for example, 1931, 1992-93 and 2008 – but also because losses tend to occur whenever a currency shifts from a fixed to a floating regime, or in other words, abandons its peg.

The study is the first to examine the long-run relationship between exchange rate regimes and carry trade returns. It finds that the collapse of currency pegs spills over into other currencies, and on average is associated with significant carry trade losses. These episodes are consistent with a global flight-to-safety by investors as they seek refuge in low-yielding, safe currencies.

A good example of such an event occurred in January 2015 when the Swiss National Bank abandoned the cap against the euro and floated the Swiss franc. Not only did the latter’s value rise by 21 per cent against the euro over the following two days, but the carry trade implemented on the remaining floating currencies experienced a five per cent loss over the next month. The Swiss National Bank’s action prompted a sharp depreciation in the values of the Australian dollar and New Zealand dollar, as investors switched into relative safe-haven currencies like the Japanese yen and the US dollar, which appreciated sharply.

The former two currencies would have been in the long portfolio and the latter two in the short portfolio of the carry trade. Hence, both legs of the strategy would have incurred losses. When examining a total of over 200 such instances of fixed-to-floating currency regime changes over the last century, the study found the occurrence of carry losses on average – a result which is consistent with a global flight-to-safety interpretation.

“This finding holds important implications for currency traders around the world,” says study co-author Dr David Chambers, Reader in Finance and Academic Director of the Centre for Endowment Asset Management at Cambridge Judge Business School. “Carry is on average a profitable strategy, but when there are regime shifts from fixed to floating currencies there is a considerable risk this strategy will experience losses.”

The study, entitled “Currency Regimes and the Carry Trade”, is co-authored by Dr Olivier Accominotti of the London School of Economics; Dr Jason Cen of University of Exeter Business School; Dr David Chambers of Cambridge Judge; and Professor Ian W. Marsh of Cass Business School, City University of London.

David discussed the study in a presentation at the recent Invesco Asia Investment Lecture Series on factor investing.

Dr David Chambers
Dr David Chambers

The study begins in 1919 because this marked the dawn of modern currency trading as we would recognise it today, and covers 19 currencies of developed countries through 2017. “The emergence of a continuously traded forward market in London alongside the spot market led to currency speculation by both banks and individuals increasing substantially during the 1920s and 1930s,” says Dr David Chambers. “John Maynard Keynes and Winston Churchill were both well-known speculators.”

The century-long sample is divided into three eras. The interwar period began with the removal of war-time capital controls in 1919 and witnessed floating currencies for a considerable proportion of the time; the Bretton Woods era ran from 1944 to 1973, in which countries agreed to fixed but adjustable exchange rates relative to the US dollar; and the post-1973 period has seen mostly floating rates.

“The carry trade was particularly profitable in the interwar period as well as the post-1973 period,” says David. “In both periods, the strategy experienced losses on average when one or more the pegged currency pairs in the sample were abandoned.”