Understanding Risk in Currency Carry Trade Strategies

ROCHESTER, N.Y., March 8, 2016 -- Whether you invest in stocks, bonds, commodities, or currencies, the carry trade is one of the most popular trading strategies in the currency market. Carry trade seeks to profit by borrowing currencies with low interest rates to invest in those with high interest rates. Historically, these strategies earn substantial profits, but the reason for this profitability remains a topic of debate.

According to new research from Simon Business School at the University of Rochester titled, "Commodity Trade and the Carry Trade: A Tale of Two Countries," trade costs of basic commodities and finished goods can explain the difference in interest rates and risk exposure between countries that are net importers of basic commodities and finished goods export producers. The study reveals that sorting currencies based on net exports of finished goods or basic commodities generates a substantial spread in average excess returns on carry trades and can be a marker for risk. The researchers modeled trade costs which adjust over time to match the demand for transporting goods between countries.

"Persistent differences in interest rates across countries account for much of the profitability of currency carry trade strategies," said Robert Ready, an assistant professor of finance from Simon Business School and co-author of the study. "Basic commodity currencies tend to have high interest rates while low interest rate currencies belong to exporters of finished goods."

The research shows that differences in average interest rates and risk exposures between countries that are net importers of basic commodities and commodity-exporting countries can be explained by analyzing trade costs.

The authors introduce a novel mechanism that helps rationalize these findings and measures convex shipping costs combined with time-varying capacity of the shipping industry.

Nonlinearity of the shipping costs implies that the consumption of the country producing the finished good is more sensitive to productivity shocks, and is thus riskier to the investor.

The study was conducted by Ready and his co-authors, Nikolai Roussanov from The Wharton School at the University of Pennsylvania, and Colin Ward from Carlson School of Management at the University of Minnesota.

To learn more about the cutting-edge research being conducted at Simon Business School, please visit www.simon.rochester.edu.

About Simon Business School
 
The Simon Business School is currently ranked among the leading graduate business schools in the world in rankings published by the popular press, including Bloomberg Businessweek, U.S. News & World Report, and the Financial Times. The Financial Times recently rated the School No. 9 in the world for finance. More information about Simon Business School is available at www.simon.rochester.edu.

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