Study Shows FX Carry Trade Really Does Work

It pays to sell low-yielding currencies and buy higher-yielding ones, at least in the long run, according to a new academic study released Friday.

Currencies watchers have puzzled over the merits of this basic investment tactic–known as the carry trade–for years, because in theory, it shouldn’t work; exchange rates could be expected to shift fast enough to neutralize any gains from investing in currencies linked to higher interest rates, and higher inflation in high-rate countries could also be expected to nibble away at returns.

But now a joint study by the Cass Business School in London, Leibniz Universitaet Hannover in Germany and Bank for International Settlements has analyzed spot and one-month forward foreign-exchange rates for 48 currencies against the dollar between 1983 and mid-2009, and it finds that the strategy on average yields more than 5% a year.

It found “surprisingly high” returns even when emerging markets, where interest rates are typically higher compared with developed economies, were excluded and after accounting for transaction costs.

Co-author Professor Lucio Sarno from the Cass Business School said the findings showed carry-trade investors being compensated for the extra risk of investing in higher-yielding currencies even though exchange-rate moves over the life of a trade would be expected to offset any yield gains in an efficient market.

“If investors are both rational and risk-neutral, exchange-rate changes should eliminate any gain from the difference in interest rates across countries,” Sarno said. “But if anything, the opposite holds true: high-interest-rate currencies tend to appreciate while low interest rates depreciate.”

The study, described by a Cass Business School spokesman as the biggest-ever based on a review of the existing academic literature, showed carry trades involving major currencies such as the yen, buck or Australian dollar were most profitable in the 1980s and 1990s and were barely impaired by two economic recessions in the early 1990s and 2000s.

Popular trades in this space have been known to blow up in dramatic fashion. Between August 2008 and January 2009, for example, the relatively high-yielding pound dropped by more than 44% against the yen.

But as a whole, it is only during the last recession and financial crisis that carry-trade returns have really dropped off, the study showed.

“Our findings suggest investors cannot escape these risks by only investing in currencies of large, developed countries as this is a general phenomenon,” Sarno said.

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