PDF Ebook Carry Trades, Momentum Trading and the Forward Premium Anomaly
Many financial market analysts have recently commented on the unprecedented growth of the carry trade in the foreign exchange (FX) market. Such trades involve the borrowing or selling of currencies with low interest rates to fund the purchase of currencies with high interest rates. Clearly, this is a speculation against uncovered interest rate parity (UIP), which is a central theory of international finance. Carry trades also appear to involve excessive risk over long horizons since they ignore the fundamentals of a currency and are also vulnerable to any sudden unanticipated changes in exchange rates.
The related strategy of momentum trading appears to be a form of bandwagon trading with traders joining existing trends that further reinforce the appreciation of currencies with high interest rates. Galati and Melvin (2004) note that the substantial increase in turnover in the FX market between 2001 and 2004 Vseems to have been driven by momentum trading and carry trades in a global search for yield (p.67)V. Furthermore, despite its widespread use, The Economist (2007) recently noted that the reasons for the success of the carry trade remain a bit of a mystery.
However, as changes in interest rates make a funding currency increasingly attractive and the volume of carry trades grows, then from recent theory on the limits to speculation and empirical evidence to be presented in this paper, there will be an increase in the speed of reversion to UIP and a vanishing of the forward premium anomaly. In deed, the carry trade has been likened to Vpicking up nickels in front of steamrollers, as reversions can occur suddenly, thus wiping out carry profits (The Economist, 2007).
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PDF Ebook Carry Trades, Momentum Trading and the Forward Premium Anomaly
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