Carry Trades Defined and their relationship to the Interest Rate Parity valuation model

A Hole in the Interest Rate Parity Theorem -- Carry Trades

However, this theory has not held true since 1990, because despite higher interest rates in the U.S. versus Japan, the USD has appreciated against the JPY. One of the reasons for this shift is the popularity of carry trades. A carry trade involves buying or lending a currency with a high interest rate and selling or borrowing a currency with a low interest rate. Investors have been moving their funds into higher yielding currencies, therefore causing the higher yielding currencies to appreciate. These trades are popular in times of risk seeking and least successful in times of risk aversion. That is in risk seeking environments, investors tend to reshuffle their portfolios and sell low risk, but high value assets and buy higher risk and low value assets. Riskier currencies - those with large current account deficits - are forced to offer a higher interest rate to compensate investors for the risk of a sharper depreciation than that predicted by uncovered interest rate parity. The profit from a carry trade is an investor's payment for taking this risk. Carry trades are more likely to go wrong in times of risk aversion, such as global economic instability and geopolitical uncertainty. In such times, the riskier currencies - upon which carry trades rely for their returns - tend to depreciate. Typically, riskier currencies have current account deficits and, as risk appetite wanes, investors retreat to the safety of their home markets, making these deficits harder to fund.

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