Carry trade strategies explained by structure of international trade
#5 – FX Carry Trade
Authors: Ready, Roussanov, Ward
Title: Commodity Trade and the Carry Trade: A Tale of Two Countries
Persistent differences in interest rates across countries account for much of the profitability of currency carry trade strategies. The high-interest rate "investment" currencies tend to be "commodity currencies," while low interest rate "funding" currencies tend to belong to countries that export finished goods and import most of their commodities. We develop a general equilibrium model of international trade and currency pricing in which countries have an advantage in producing either basic input goods or final consumable goods. The model predicts that commodity-producing countries are insulated from global productivity shocks through a combination of trade frictions and domestic production, which forces the final goods producers to absorb the shocks. As a result, the commodity country currency is risky as it tends to depreciate in bad times, yet has higher interest rates on average due to lower precautionary demand, compared to the final-good producer. The carry trade risk premium increases in the degree of specialization, and the real exchange rate tracks relative technological productivity of the two countries. The model's predictions are strongly supported in the data.
Notable quotations from the academic research paper:
"A currency carry trade is a strategy that goes long high interest rate currencies and short low interest rate currencies. A typical carry trade involves buying the Australian dollar, which for much of the last three decades earned a high interest rate, and funding the position with borrowing in the Japanese yen, thus paying an extremely low rate on the short leg. Such a strategy earns positive expected returns on average, and exhibits high Sharpe ratios despite its substantial volatility. In the absence of arbitrage this implies that the marginal utility of an investor whose consumption basket is denominated in yen is more volatile than that of an Australian consumer. Are there fundamental economic dierences between countries that could give rise to such a heterogeneity in risk?
One source of dierences across countries is the composition of their trade. Countries that specialize in exporting basic commodities, such as Australia or New Zealand, tend to have high interest rates. Conversely, countries that import most of the basic input goods and export finished consumption goods, such as Japan or Switzerland, have low interest rates on average. These differences in interest rates do not translate into the depreciation of
"commodity currencies" on average; rather, they constitute positive average returns, giving rise to a carry trade-type strategy. In this paper we develop a theoretical model of this phenomenon, document that this empirical pattern is systematic and robust over the recent time period, and provide additional evidence in support of the model's predictions for the dynamics of carry trade strategies.
We show that the 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 appealing to a natural economic mechanism: trade costs.
We model trade costs by considering a simple model of the shipping industry. At any time the cost of transporting a unit of good from one country to the other depends on the aggregate shipping capacity available. While the capacity of the shipping sector adjusts over time to match the demand for transporting goods between countries, it does so slowly, due to gestation lags in the shipbuilding industry. In order to capture this intuition we assume marginal costs of shipping an extra unit of good is increasing – i.e., trade costs in our model are convex. Convex shipping costs imply that the sensitivity of the commodity country to world productivity shocks is lower than that of the country that specializes in producing the final consumption good, simply because it is costlier to deliver an extra unit of the consumption good to the commodity country in good times, but cheaper in bad times. Therefore, under complete financial markets, the commodity country's consumption is smoother than it would be in the absence of trade frictions, and, conversely, the commodity importer's consumption is riskier. Since the commodity country faces less consumption risk, it has a lower precautionary saving demand and, consequently, a higher interest rate on average, compared to the country producing manufactured goods. Since the commodity currency is risky – it depreciates in bad times – it commands a risk premium. Therefore, the interest rate differential is not offset on average by exchange rate movements, giving rise to a carry trade.
We show empirically that sorting currencies into portfolios based on net exports of finished (manufactured) goods or basic commodities generates a substantial spread in average excess returns, which subsumes the unconditional (but not conditional) carry trade documented by Lustig, Roussanov, and Verdelhan (2011). Further, we show that aggregate consumption of commodity countries is less risky than that of finished goods producers, as our model predicts"
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