Risk in carry trades: a look at target currencies in Asia and the PacificThe article is an analysis of the risk involved in carry trading as an investment strategy. The article examines carry trade involving five Asian and Pacific currencies-the Indonesian rupiah, Australian dollar Philippine peso, Indian rupee, New Zealand dollar and as target currencies Carry trading is a strategy that involves borrowing from one currency that has low interest rates and then investing in a currency that has high interest rates. The low interest rate currency is the funding currency and the high interest rate currency is known as the target currency.
The carry trade strategy is aimed at earning from the interest rate differential or the difference in interest rates between the target currency and the funding currency since the high interest rates yield higher returns which should be sufficient to cover the interest of the funding currency with a surplus. In essence, a carry trader or carry trading investor pays interest on the currency position they sell( funding currency) and collect the interest on the currency position they buy(target currency) as earnings (Gyntelberg & Remolona 73).
In order for the carry trade strategy to work, the higher yielding currency or the target currency should not depreciate at a rate equal to or more than the interest differential. This means that the uncovered interest rate parity-UIP should not hold. If the high yielding currency depreciates at a rate equal to the interest rate differential, the expected earnings from carry trading will be wiped out or the depreciation will equalize the returns. UIP offsets the interest rate differential earnings. However, evidence from empirical literature has shown that UIP is almost always guaranteed to fail in time periods shorter than five years.
It has emerged that the reverse happens. That is, target currencies have actually appreciated contrary to the UIP assumption while the funding currencies have continued to depreciate. This is known as the forward premium puzzle. A study by Remolona and Schrijvers (2003) documents the failure of UIP especially when investors chose to hold investment instruments with long term maturities exceeding the investment horizon such as treasury bonds (Remolona & Schrijvers 68).
Carry trading has increasingly become a preferred investment strategy in currency markets. This has mainly been as a result of the failure of UIP. Traders seem to be aware of the failure of UIP which has emboldened their resolve to incur the risks involved in carry trading since the continued appreciation of target currencies in tandem with the depreciation of funding currencies poses lucrative returns for carry trading. Carry trading as an investment strategy is also frequently pursued when the interest rate differential between the target currency and the funding currency is wide enough to compensate for the foreign exchange risk.
As a result, carry trading has often shied away from using major world currencies such as the US dollar or the Euro as target currencies to ensure significant interest rate differentials. Common target currencies include the Australian dollar, South African rand, Swedish kroner and Turkish lira. Currencies managed by floating or market-based flexible exchange rate regimes such as the Brazilian real Czech koruna, Hungarian forint, Indian rupee, Indonesian rupiah and Philippine peso have also been used at times(Gyntelberg & Remolona 76).