Post by Sapphire Capital on Jul 11, 2008 7:16:22 GMT 4
Arbitrage Capital and Currency Carry Trade Returns
PETRI T. JYLHA
Helsinki School of Economics
JUSSI-PEKKA LYYTINEN
Helsinki School of Economics
MATTI J. SUOMINEN
Helsinki School of Economics
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April 15, 2008
Abstract:
We develop a model based on risk averse investors and limited arbitrage capital to explain the rationale for the so called carry trades: that is, trades where "the purchase of riskier, higher-yielding assets is funded by selling lower-yielding currencies" (Financial Times, January 28, 2008). Due to differences in risk and limited arbitrage capital, in our model the returns to carry trades are positive, but decrease in the amount of arbitrage capital. In the empirical part of the paper, using 32 years of exchange rate data, we document several new results related to carry trades and provide empirical support for the model's predictions. We empirically document that 1) the interest rate and inflation risk in high interest rate currencies are indeed higher and 2) there is a significant correlation of carry trade returns with the hedge fund indices, which suggests that carry trades are indeed used by arbitrageurs. Other main empirical results are 3) the positive returns to carry trades have been decreasing over time in parallel with an increase in arbitrage capital 4) entry into our "carry trade" long (short) portfolio leads initially to an appreciation (depreciation) of the corresponding currency, inconsistent with the uncovered interest rate parity and 5) the currency impact from entry into our "carry trade" portfolio depends strongly on the amount of arbitrage capital. At the time of the paper, US Dollar has exited and been replaced by Euro in the "carry trade" long portfolio, making the analysis and predictions particularly timely from US and European perspectives.
papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1123425_code857923.pdf?abstractid=1113812&mirid=4
PETRI T. JYLHA
Helsinki School of Economics
JUSSI-PEKKA LYYTINEN
Helsinki School of Economics
MATTI J. SUOMINEN
Helsinki School of Economics
--------------------------------------------------------------------------------
April 15, 2008
Abstract:
We develop a model based on risk averse investors and limited arbitrage capital to explain the rationale for the so called carry trades: that is, trades where "the purchase of riskier, higher-yielding assets is funded by selling lower-yielding currencies" (Financial Times, January 28, 2008). Due to differences in risk and limited arbitrage capital, in our model the returns to carry trades are positive, but decrease in the amount of arbitrage capital. In the empirical part of the paper, using 32 years of exchange rate data, we document several new results related to carry trades and provide empirical support for the model's predictions. We empirically document that 1) the interest rate and inflation risk in high interest rate currencies are indeed higher and 2) there is a significant correlation of carry trade returns with the hedge fund indices, which suggests that carry trades are indeed used by arbitrageurs. Other main empirical results are 3) the positive returns to carry trades have been decreasing over time in parallel with an increase in arbitrage capital 4) entry into our "carry trade" long (short) portfolio leads initially to an appreciation (depreciation) of the corresponding currency, inconsistent with the uncovered interest rate parity and 5) the currency impact from entry into our "carry trade" portfolio depends strongly on the amount of arbitrage capital. At the time of the paper, US Dollar has exited and been replaced by Euro in the "carry trade" long portfolio, making the analysis and predictions particularly timely from US and European perspectives.
papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1123425_code857923.pdf?abstractid=1113812&mirid=4