"Crash and carry: New research suggests a way to make steady profits from the carry trade"

I'm going through our bookmarks from December to find the stories we didn't get to post when they were topical but are still worth a read. Here's one from the Economist:

WHEN pundits worry about the distorting effects of cheap money on asset prices, they invariably single out the carry trade as a cause for concern. The term is often used loosely to describe any investment that looks suspiciously profitable. More specifically it refers to a particular sort of foreign-exchange trading: that of borrowing cheaply in a “funding” currency to exploit high interest rates in a “target” currency. The yen has long been a favoured funding currency for the carry trade because of Japan’s permanently low interest rates. As a result of the crisis and near-zero rates in America, the dollar has become one, too.

If markets were truly efficient, carry trades ought not to be profitable because the extra interest earned should be exactly offset by a fall in the target currency. That is why high-interest currencies trade at a discount to their current or “spot” rate in forward markets. If exchange rates today were the same as those in forward contracts, there would be an opportunity for riskless profit. Arbitrageurs could buy the high-interest currency today, lock in a future sale at the same price and pocket the extra interest from holding the currency until the forward contract is settled.

In practice, the forward market is a poor forecaster. Most of the time exchange rates do not adjust to offset the extra yield being targeted in carry trades. So a simple strategy of buying high-yielding currencies against low-yielding ones can be rewarding for those that pursue it. The profits are volatile, however, and carry trades are prone to infrequent but huge losses. In late 2008 the yen rose by 60% in just two months against the high-yielding Australian dollar, a popular target for carry traders. That made it much more expensive to pay back yen-denominated debt.

If efficient-market theory cannot kill the carry trade, why don’t volatile returns, and the occasional massive loss, scare off investors? A new paper* by Òscar Jordà and Alan Taylor of the University of California, Davis, may have the answer. They find that a refined carry-trade strategy—one that incorporates a measure of long-term value—produces more consistent profits and is less prone to huge losses than one that targets the highest yield....MORE