BIS confirms continuing importance of carry trade

Foreign exchange carry trades continue to be a main driver of global exchange rate movements, according to the Bank for International Settlements' 2007 annual report.

Carry trades typically involve using derivatives to go long on high-yielding currencies, while simultaneously shorting low-yielding currencies. Investors benefit from the difference in yields, provided they are not offset by moves in exchange rates.

In the year to March 2007, low volatility and large interest rate differentials led to an increasing build-up of carry trades, the report said.

The low-yielding Japanese yen and Swiss franc were the main funding currencies for carry trades, the report confirmed. Meanwhile, the Australian and New Zealand dollars, Brazilian real, Hungarian forint and South African rand were the main targets.

“Carry trades arguably supported appreciating trends of the target currencies,” the report stated. “In May-June 2006 and February 2007, however, an unwinding of these strategies might have contributed to the weakening of the target currencies and the strengthening of the funding ones.”

The carry trade was generally profitable throughout most of 2006 and early 2007 on a risk-adjusted basis, according to the report. It said data showed yen-funded trades were particularly attractive in 2006, although the profitability of carry trades fell during periods of heightened market volatility.

The report cautioned that estimating the size of the carry trade and its impact on exchange rates is “notoriously difficult”. Nevertheless, it cited data supporting its importance from the Chicago Mercantile Exchange, foreign exchange market turnover, and a regression analysis of hedge fund returns.