The answer seems affirmative. We compare currency carry trades with an investment strategy based on currency fundamentals: taking a long (short) position in undervalued (overvalued) currencies. Carry trades have high risk-adjusted returns, but are subject to "crash risk." In contrast, the fundamental strategy has lower risk-adjusted returns, but is less prone to crash risk, because the realization of crash risk coincides with corrections towards fundamentals. In particular, the fundamental strategy outperformed carry trades during the recent global financial crisis. Building on these results, we present early warning indicators for potential turbulence in the currency market.
I. I ntroduction
Currencycarrytrades have attracted investors because of their high risk-adjusted returns. Carry traders take a short position in a currency with a low interest rate and a long position in a currency with a high interest rate. For example, before the onset of the jitters in global financial markets in the summer of 2007, a typical carry trade strategy comprised a short position in the Japanese yen and a long position in the New Zealand dollar. As documented by many researchers, carry traders take advantage of the “forward premium puzzle
This paper explores how much of the movements in the sovereign spreads of Asian economies over the course of the global financial crisis has reflected shifts in (i) global risk aversion; (ii) country-specific risks, directly from worsening fundamentals, and indirectly from spillovers originating in other sovereigns and the uncertainty surrounding exchange rates. Earlier in the crisis, the increase in market-implied contagion led to higher Asian sovereign bond yield spreads over swaps. But, after the crisis, Asia’s sovereign spreads normalized, despite the debt crisis in the euro area, reflecting a fall in both exchange rate and spillover risks.
China’s growth performance since the start of economic reforms in 1978 has been impressive, but the gains have not been distributed equally across provinces. We use a nonparametric approach to analyze the variation in labor productivity growth across China’s provinces. This approach imposes less structure on the data than the standard growth accounting framework and allows for a breakdown of labor productivity into efficiency gains, technological progress, and capital deepening. We have the following results. First, we find that on average capital deepening accounts for about 75 percent of total labor productivity growth, while efficiency and technological improvements account for about 7 and 18 percent, respectively. Second, technical change is not neutral. Third, whereas improvement in efficiency contributes to convergence in labor productivity between provinces, technical change contributes to productivity disparity across provinces. Finally, we find that foreign direct investment has a positive and significant effect on efficiency growth and technical progress.
Japan points to a broader notion of the carry trade. Yen liabilities fund not only pure currencycarrytrades, but also fund the general increase in balance sheets of hedge funds and financial intermediaries. Finally, we have shown that the difference in overnight rates across countries is a crucial determinant of balance sheet changes. Therefore, the short-term interest rate may be more important as a gauge of the stance of monetary policy than is given credit for by current monetary thinking. Domestic monetary policy has a global dimension through the workings of
liquid) currencies. Similarly, the financial crisis led to a reversal in currencycarrytrades, implying a sharp depreciation in currencies that had previously experienced long appreciation sprints. These sharp movements in exchange rates might have significant effects on market expectations about future developments in the currency spectrum, in turn affecting demand for bonds denominated in a particular currency. In addition, exchange rate movements can have an important impact on sovereign risk perceptions if, for instance, most of the public debt of a given country
financial crisis in 2007, and associated plunge in commodity prices. More recently, banks remained profitable and credit continued to grow at a robust pace, despite the fall in commodity (metals) prices in 2011 and associated deterioration in Peru’s terms of trade.
BIS , ( 2015 ), CurrencyCarryTrades in Latin America . BIS Papers, 81 . Basel : Bank for International Settlements .
Cabello , Miguel , Jose Lupu , And Elias Minaya . 2017 . Macroprudential Policies in Peru: The Effects of Dynamic Provisioning and Conditional
International Monetary Fund. Monetary and Capital Markets Department
since late 2008 ( Figure 1.34 ). 46 Furthermore, mature market banks’ willingness to lend is only gradually improving, and the growth of domestic bank credit in most emerging market and other advanced economies is only beginning to turn around. The exception is in China, where credit growth soared through mid-2009 and remains at a fast pace, although decelerating ( Figure 1.35 ).
Figure 1.34. Incentives for Foreign CurrencyCarryTrades Are Recovering
Sources: Bloomberg L.P.; and IMF staff estimates.
Figure 1.35. Real Domestic Credit Growth and Equity