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 di erences between countries that could give rise to such a heterogeneity in risk?

One  source  of  di erences  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  fi nished  consumption  goods,  such  as  Japan  or  Switzerland,  have  low  interest rates on average.  These diff erences 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 diff erences 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 di fferential is not off set 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 fi nished (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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