US Dollar Carry Trades In The Era Of ‘Cheap Money’
Queen’s University Belfast – Finance
RPM Risk & Portfolio Management AB, Stockholm, Sweden
Queen’s University Belfast – School of Management
University of Warwick – Warwick Business School
April 10, 2016
In this paper, we employ a unique dataset of actual US dollar (USD) forward positions against a number of currencies taken by so-called Commodity Trading Advisors (CTAs). We investigate to what extent these positions exhibit a pattern of USD carry trading or other patterns of currency trading over the recent period of the ultra-loose US monetary policy. Our analysis indeed shows that USD positions against emerging market currencies are characterised by a pattern of carry trading. That is, the USD, as the lower yielding currency, is associated with short positions. The payoff distributions of these positions, moreover, are found to have positive Sharpe ratios, negative skewness and high kurtosis. On the other hand, we find that USD positions against other advanced country currencies have a pattern completely opposite to carry trading which is in line with uncovered interest parity trading; that is, the lower (higher) yielding currency is associated with long (short) positions.
US Dollar Carry Trades In The Era Of ‘Cheap Money’ – Introduction
In this paper, we employ and analyse a unique data set of actual US dollar forward positions versus a number of emerging and advanced market currencies. Our objective is to shed a light on the characteristics of the currency trading styles implied by these positions during a recent sample period, with an emphasis on USD carry trading6. The motivation behind this emphasis is the near-zero US interest rate over the vast majority of our sample period.
Currency carry trading implies that traders invest in higher yielding currencies (investment or target currencies) using borrowings in lower yielding currencies (funding currencies). So, by USD carry trading we mean the carry trades in which the US dollar is the funding currency. Under the assumption of the covered interest rate parity (CIP), this strategy can be implemented in the foreign exchange (FX) forward markets by taking long positions in currencies which are traded on forward discount (high interest rate currencies) and short positions in currencies which are traded on forward premium (low interest rate currencies). The motivation behind currency carry trading is the well-established finding of the downward bias in the unbiasedness hypothesis (UH) predictions, i.e. the forward premium bias puzzle (see e.g. Fama, 1984; Frankel and Chinn, 1993; Bansal and Dahlquist, 2000; Frankel and Poonawala, 2010 among others). The standard expression of this hypothesis is through the Fama regression of7:
Where is the natural log of the spot exchange rate at time is the forward premium (log difference of the k-period forward rate and spot rate at time t) and is the error term. The null hypothesis is that and is a white noise process which implies that currency excess return is expected to be zero.
In contrast, the well-documented finding of significantly less than unity and, more often, negative slope coefficient implies that positive currency excess return can be achieved by trading on currency interest differentials (on the carry). Carry trades have been found to be profitable on average with an attractive Sharpe ratio compared to stock and bond markets (see e.g., Hochradl and Wanger, 2010; Pojarliev, 2005; Burnside et al., 2006; 2007; 2008; Gilmore and Hayashi, 2011; Menkhoff et al., 2012). The traditional common target currencies are found to include the Australian dollar, New Zealand dollar, Mexican peso, Brazilian real, Indian rupee, while funding currencies include mainly the Japanese yen and the Swiss franc (see Bilson, 2013; Galati and Melvin, 2004; Galati et al., 2007; McGuire and Upper, 2007; Gagnon and Chaboud, 2007; Curcuru et al., 2010).
In the wake of the 2007-2008 financial crisis, many countries, especially developed countries including the USA, have adopted unconventional loose monetary policies with the purpose of stimulating their sluggish and unstable economies. This period is termed in the financial press as “the era of cheap money”. On the other hand, other countries, especially emerging markets, have maintained relatively high interest rates over the same period. Because of the potential impact of these effects on the trading decisions of the FX traders, it is worthwhile to consider currency trading in general and USD carry trading in particular over the sample period of the paper. For example, Gilmore and Hayashi (2011) find a strong relation between currency excess return and the carry. Spronk et al. (2013) show that the more important the interest rate differential, the more attractive the currency carry trading. It is also suggested that the relatively high-yielding emerging markets have been major recipients of carry trade flows in the wake of the crisis, and that this flow represents a “global search for yield” which is triggered by the unconventional expansion monetary policy of advanced economies (see e.g. Kim, 2015; Mishra et al., 2014). For a set of major currencies, Briere and Drut (2009) document the superiority of “fundamentals-based” trades over carry trades when uncertainty is high.
In light of this, the crux of the paper is to analyze our dataset of the US dollar forward positions to find out to what extent they show characteristics of US dollar carry trading or another trading strategy over the recent period of record-low US interest rates. In other words, we investigate whether these positions exhibit a response to the very low US interest rates by having a pattern of US dollar carry trading or other patterns of trading strategies can be identified across different currency markets. The distinctive feature of this study is that we have access to a dataset of daily-aggregated US dollar forward positions against a number of advanced and emerging currencies. It is collected from a Swedish investment specialist, Risk & Portfolio Management AB (RPM) which is a fund of hedge funds investing in Managed Futures strategies which are also known as Commodity Trading Advisors (CTAs). CTAs engage in various strategies like trend-following, short-term trading, and global macro that often employs carry trading as a sub-strategy.
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