Staff Studies - Volume 44 Numbers 1 & 2
CENTRAL BANK OF SRI LANKA
Carry trade strategy is a popular investment strategy when it comes to Foreign Exchange
trading. According to Uncovered Interest Parity (UIP), the exchange rates will eliminate
the returns received from the difference of interest rate across the respective countries.
A carry trade can also be fulfilled via buying a foreign currency forward when it's at a
forward discount or vice versa. The main idea is to borrow the low yielding currencies
and invest in the high yielding currencies, thereby earning the spread in between. Even
though theoretically we assume an arbitrage free environment, reality says otherwise
Fama (1984) confirms that regression of exchange rate changes with respect to the change
in interest rate yields a value less than 1, while it has to be equal to 1 according to
UIP. That is, the returns on the high yielding currency does not equal the return on
the low yielding currency taken with the expected appreciation of the foreign currency.
Fama (1984) recognizes this flaw of UIP as the "forward premium puzzle". Despite the
historical evidence of high returns, the carry trade positions will be exposed to higher
risk as the volatility of the currency increases. The borrowers will try to close their debt
positions against the respective lenders if the borrowing currencies start appreciating.
Moreover, academic evidence indicates that carry trades often suffer large losses during
insecure markets conditions, even though such trades perform well in conducive markets
. 2013, Liu
In practice, developing countries account for higher interest rates on investments and
therefore an attractive carry trade opportunity for the investors. On the other hand,
investors are more concerned about the risk of the opportunity despite the attractiveness
of the opportunity. In this context, the question arises whether the carry trade returns
influence the respective crash risk. Further it is observable that most active carry traders
are present in major emerging market currencies. Therefore if one currency crashes, there
exists a high probability that it might spread to other surrounding economies. Despite the
strength of the economy, the regulators of financial institutions are more concerned with
the extreme events which might force the liquidation of the financial institution leading to
an imbalance in the financial system. Therefore, this paper intends to focus this research
specifically on tail risk which is frequently used by regulators in order to access the funding
limits of the investors. Moreover, should the investors be concerned about the tail risk at
all when they invest in high interest rate currencies?
The most trivial way to estimate tail risk is to assume that returns are normally distributed.
However, due to the inefficiency of this assumption, later studies
utilised more heavy
tailed distributions such as student-t. Both these methods are most likely to either
Please refer to Kole and Verbeek (2006).