Interest rates, carry trades, and exchange rate movements

Michele Cavallo
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Michele Cavallo: https://www.federalreserve.gov/econres/michele-cavallo.htm

FRBSF Economic Letter, 2006, issue nov17

Abstract: The U.S. dollar has seen some remarkable swings against major currencies recently. For example, over most of 2005, it gained nearly 18% against the yen and 13% against the euro, while between March and May 2006, it depreciated sharply against these currencies, losing almost 10% of its value. Many observers have related these swings to what is known as the carry trade. This is a strategy widely used by investors in international financial markets that is based on exploiting the existence of interest rate differentials across countries. ; The use of this strategy by investors is puzzling, as the theory of interest parity conditions implies that it should not generate predictable profits. This Economic Letter explores this puzzle by first describing the structure of a carry trade transaction. It then reviews research documenting the payoff properties of carry trades and discusses how these strategies can be linked to the swings in exchange rates observed over recent years. Finally, it presents some evidence on the size of carry trade strategies.

Keywords: Foreign; exchange; rates (search for similar items in EconPapers)
Date: 2006
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