Feb 22nd 2012, 15:11 by Buttonwood
FEW articles on the foreign exchange markets are complete without a mention of the carry trade, under which investors borrow in low-yielding currencies and deposit the proceeds in higher-yielding currencies, in the hope of making a turn. Over the last 40 years, this has been a highly successful strategy; research by Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School (published in Credit Suisse's global investment returns yearbook) found that the annual return since 1971 (when Bretton Woods collapsed) has been 2.3%.
Of course, theory suggests there should be no return from such an approach. High interest rates should be the return investors demand for the risk of currency depreciation*. A reliable return from the carry trade suggests that investors are consistently overestimating the risk of depreciation; creating a "free lunch" for those who take the opposite view.
But have the last 40 years been an anomaly? Not necessarily. The strategy produced an even higher annual return from 1950-1071, under Bretton Woods. There was a small, negative return from 1900-1950 but even this period has a puzzle. The academics reasoned that the problem was high interest rates in the early 20th century were the result of high inflation. So they ran the numbers again, using real, rather than nominal, rates. On that basis, 1900-1950 was actually the best of the periods, with an average return of 3.1% a year. Over the entire period 1900-2011, using real rates for the carry trade was a better approach than using nominal rates, with an annual return of 2.3% against 1.1%.
Why does it work at all? The LBS profs cite the work of John Cochrane who suggests there is a risk premium involved; sometimes high-yielding currencies do suffer massive devaluations and carry traders lose a great deal. Often, these events occur ar a time of financial crises, when other asset classes are collapsing. Still, the carry trade resembles another market anomaly discussed by Dimson, Marsh and Staunton - momentum. The naive strategy of buying last year's best stocks has earned far higher returns than might be expected. One has to developed some very convoluted arguments about risk premia if one is to make these effects consistent with efficient market theory.
*Indeed, the currency forward markets exactly reflect the interest rate differential. If, as a US investor, you wanted to put your money in higher-yielding Australain dollars for a year and simultaneously sell your Australian dollars in the forward market, you would find no profit in the transaction. You cannot lock in the gain; you have to take the risk.
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The first time I came across this term years ago I was puzzled. What is "carry" and how is it being traded? So in the best British tradition I covered up with ignorance and replied, "Carry on, James."
I am still puzzled (on the etymology). Perhaps fellow blogger Johnson can enlighten us :-)
Just guessing, but I expect that the term is based on the imagery of someone actually "carrying" cash (in burlap sacks, perhaps, or brown paper bags) from the country where it can be cheaply borrowed to the one where it is dearly lent out.
The market does not set interest rates used in the carry trade, so its just a matter of hedge funds guessing where central planners will keep rates. Central planners tend to make rate changes slowly to avoid roiling the markets. Central planners even take into consideration the carry trade when making changes, because they want bank loans extended to hedge funds for the carry trade to be repaid.
#corrections: 1950-1971, not 1950-1071
also: "One has to developed"
"The naive strategy of buying last year's best stocks has earned far higher returns than might be expected."
On the other hand, the naive strategy of buying last year's best mutual fund earns a highly *negative* return.
In this blog, our Buttonwood columnist grapples with the ever-changing financial markets and the motley crew who earn their living by attempting to master them. The blog is named after the 1792 agreement that regulated the informal brokerage conducted under a buttonwood tree on Wall Street.
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