BIS Quarterly Report 0712 Carry Trade

Jacob Gyntelberg

Eli M Remolona

[phone] [e-mail] [phone] [e-mail] Risk in carry trades: a look at target currencies in
Asia and the Pacific 1
We analyse carry trades involving the Australian dollar, Indonesian rupiah, Indian rupee, New Zealand dollar and Philippine peso as target currencies. We find evidence supporting the view that downside risk is an important feature of such strategies and propose ways of measuring this risk.
JEL classification: F310, G150, G180, N250.

Carry trades are often viewed as a highly speculative investment strategy, to be tried only by the most sophisticated investor. Empirically, however, these trades have been shown to perform well quite consistently for protracted periods and have thus become a fairly common strategy. Confirming this observation is the fact that market participants have created tradable indices as well as various forms of structured FX instruments referencing carry trade strategies. Based on a sample of target currencies in Asia and the Pacific, we find that carry trades have had extraordinarily high returns but also a risk of large losses. This finding suggests that carry trade returns may, at least in part, reflect compensation for very large downside risks. On balance, our analysis of carry trades involving target currencies in Asia and the Pacific does indeed show that the perceived risks of carry trading would be captured well by focusing on downside risk. Using value-at-risk (VaR) and expected shortfall as measures of downside risk, we find a positive relationship between risks and returns for carry trades.
This special feature is organised as follows. In the first section we briefly review the literature on uncovered interest parity (UIP), a condition that would make carry trades unprofitable. The second section presents alternative measures of risk for carry trades, focusing on five target currencies in Asia and

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The authors are grateful for useful

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