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Speculation and exchange rate adjustment failure
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Speculation and exchange rate adjustment failure

34 Seiten · 7,23 EUR
(März 2009)

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This paper provides an intuitive account of patterns and characteristics of carry trades which are gaining increasing acknowledgment in the very recent academic and policy oriented literature. The Bank for International Settlements (BIS 1999) has been the first institution that has identified the yen carry trade as a potential source of volatility and studied its relation with hedge funds earnings. Burnside at al. (2006) show the properties of returns to carry trades based on the so called “forward premium puzzle”. The tendency of a currency at a premium (discount) to depreciate (appreciate) can be exploited to sell (buy) forward low-yielding (high-yielding) currencies. Burnside at al. (2006, 2008) explore the returns of this strategy for developed country and for paying back the funding currency can add to the gains, or induce smaller gains or even losses. But with stable exchange rates, the interest rate gain amounts to 4.75 per cent. However, both gains and losses are largely magnified by high leverage ratios, since traders typically use huge amounts of borrowed funds and very little equity.

For instance, owning a capital of $10 and borrowing 10 times the equivalent of that value in yen, the leverage factor of 10 leads to a net interest return on equity of 47.5 per cent. Speculation and exchange rate adjustment failure 81 developed and emerging market currencies, respectively. The obtained high Sharpe ratios are uncorrelated to traditional risk factors and cannot represent a simple compensation for risk. Our research is based on the research approach developed in late 2006 for UNCTAD (2007). We use monthly data within overlapping quarterly periods to obtain the returns from borrowing from low-yielding and targeting high-yielding currency. We intuitively explore the relation between these returns and the inflation and monetary policy stance (also measured within overlapping quarterly periods) for selected developed and developing countries as well as regions. Galati et al. (2007) provide the first systemic measure of the size of this form of speculation. Carry trade flows identification and monitoring is problematic because of lack of data and the variety of forms that these flows can take. They compare carry-to-risk ratios (the three-month interest rate differential divided by the implied volatility of the currency option) and confirms part of the evidence of UNCTAD (2007): there is a clear tendency for the currencies of some developing countries like the Brazilian real and the Turkish lira to become increasingly more attractive than traditional carry trade targets such as the Australian and New Zealand dollars and the pound sterling. As in La Marca (2007), the present paper gives a visual association between the process of unwinding of carry trade positions and the increase of exchange rate volatility. These patterns have been confirmed by a series of researches analyzing the shape of the distribution of the carry trade returns.

The paper is organized as follows. Section 2 describes the role of carry trade positions, broadly defined as highly-leveraged cross-country operations exploiting interest-differentials and low currency volatility, in the current diverging pattern of global imbalances and real exchange rates. The paradox of the current pattern of world trade and financial imbalances, where overvalued currencies may appreciate and undervalued currencies may depreciate, the tendency to appreciation of high-interest rate currency and depreciation of low-yielding currencies, as well as the volatility associated with the unwindings have real costs in terms of real exchange rate volatility and high real interest rates. Section 3 gives a graphical account of these factors.

In Section 4, it is pointed out how national and international policies need to address the major sources of imbalance by providing an institutional framework that would reduce the potential for speculative flows and promote coordinated efforts for exchange-rate adjustment and stable real exchange rates. Section 5 concludes.

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the authors
Dr. Heiner Flassbeck
Heiner Flassbeck

Senior Economic Advisor bei der UNCTAD, Genf.

[weitere Titel]
Massimiliano La Marca

ist Wirtschaftsforscher in der Abteilung Globalisation and Development Strategies bei der UNCTAD in Genf