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Interest rates, carry trades, and exchange rate movements

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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.

Suggested Citation

  • Michele Cavallo, 2006. "Interest rates, carry trades, and exchange rate movements," FRBSF Economic Letter, Federal Reserve Bank of San Francisco, issue nov17.
    • Handle: RePEc:fip:fedfel:y:2006:i:nov17:n:2006-31
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    Cited by:

    1. Ahmed, Jameel & Straetmans, Stefan, 2015. "Predicting exchange rate cycles utilizing risk factors," Journal of Empirical Finance, Elsevier, vol. 34(C), pages 112-130.
    2. Bianca De Paoli & Jens Søndergaard, 2017. "Revisiting the Forward Premium Anomaly Using Consumption Habits: A New Keynesian Model," Economica, London School of Economics and Political Science, vol. 84(335), pages 516-540, July.
    3. Grenville, Stephen, 2011. "The Impossible Trinity and Capital Flows in East Asia," ADBI Working Papers 319, Asian Development Bank Institute.
    4. Ali Shehadeh & Peter Erdos & Youwei Li & Michael Moore, 2016. "US Dollar Carry Trades in the Era of "Cheap Money"," Czech Journal of Economics and Finance (Finance a uver), Charles University Prague, Faculty of Social Sciences, vol. 66(5), pages 374-404, October.
    5. Spronk, Richard & Verschoor, Willem F.C. & Zwinkels, Remco C.J., 2013. "Carry trade and foreign exchange rate puzzles," European Economic Review, Elsevier, vol. 60(C), pages 17-31.
    6. repec:ebl:ecbull:v:13:y:2007:i:2:p:1-7 is not listed on IDEAS
    7. Hideki Nishigaki, 2007. "Relationship between the yen carry trade and the related financial variables," Economics Bulletin, AccessEcon, vol. 13(2), pages 1-7.

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    Keywords

    Foreign exchange rates;

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