Interest rate parity and the zero-sum nature of currency trades predict that low interest currencies will appreciate and high interest currencies will depreciate over time.
Doing a carry trade assumes that the low interest currency will depreciate, stay flat or maybe slightly appreciate against the higher interest currency which goes against interest rate parity.
As more and more people do carry trades, they will pump up the value of the higher interest rate currency, creating a “bubble”. The carry trade will seem to work as long as you were one of the first people in and the people performing the carry trade after you will keep pumping up the bubble (the higher interest rate currency) like a ponzi scheme.
Is there anything seriously wrong with this way of thinking?
A ponzi scheme is something where you pay off current investors with funds provided by new investors. Eventually you run out of new investors and cannot make payments and the ponzi scheme collapses. If you exited before people ran out of new investors, you keep your money (unless the law comes after you), otherwise you are left with nothing.
I don’t think the carry trade fits a ponzi scheme. It is potentially bubble-prone, though, particularly with smaller-circulating currencies, where the actions of only a few major players can make dramatic differences in demand for the currencies.
But most major currency markets are so deep and liquid that you don’t really get bubbles. You get periods where carry trades stop performing or reverse and people who use leverage can get wiped out, but what makes it feel like bubbles is the leverage of the actors, so their equity curves look like bubbles, but the currency charts don’t look like bubbles.
Outside of emerging markets, if you look at currency charts, you don’t really see the kind of bubble behavior that you see in stocks. Currencies tend to roll over more than crash, unless there is some gross mismanagement on the part of the central bank or fiscal authorities.
I think a big part of what IRP misses is the importance of direction of interest rates. I’m not a currency guy, but it seems pretty obvious to me that when interest rates drop significantly (usually due to government policy) then that currency gets killed.
Likewise, it seems obvious that if you borrow Yen at 0% now and invest in Renminbi assets, you are going to earn a positive return.
I’m not a currency person so I could be mistaken, but it seems that carry trade is a far cry from a Ponzi scheme. It’s like people who say the stock market is a Ponzi scheme because they always buy at the top.
I don’t think there’s much dispute about covered interest rate parity (at least for large developed markets), it’s more about uncovered parity. C-IRP is about the connection between forward exchange rates, spot exchange rates, and the interest rate differential. Everything can be measured, so it’s easy to test. UC-IRP replaces the forward rate with the expected spot rate. Unlike the forward rate, the expected spot rate can’t be measured. More difficult.
I find it more convenient to think of interest rate differentials and spot rates forming a cointegrating relationship. The same can be said for inflation differentials. Over the long run, they tend to converge, but there can be significant short-term deviations.
I seem to recall Soros said that he never really was able to figure out the currency markets, which is ironic, because his most famous trade was a currency bet.
^ I’m with Soros. People who want to dabble in currency trading are nuts. It’s pure speculation and gambling. Unless you have skin in the game with a AP or AR in another currency, you should just stay away.
How can an analyst understand all of the monetary policies, fiscal policies, political policies, macroeconomic conditions, and market sentiment of not just one country, but several; and play the currency direction appropriatly. Futhermore, you have quant shops running triangular arbitrage out to the thousand’s decimal point correcting immediate inefficiencies. To me it’s just rubbish to try and ‘invest’ in currency. Three things will happen.
You’ll lose a lot of money.
You’ll make some (not alot of) money.
You’ll waste a lot of time doing all of the analysis. The monetary return on your time will be miniscule.
There are far easier rocks to turn over for a nearly free lunch than the currency markets.
I’m a moderator on a money and investment forum on, of all things, a sports car site.
Every once in a while someone will start a thread asking for advice on forex trading. My advice is always the same: send your money to me; you’re going to lose it anyway, it’s a lot more efficient to do it in one transaction than in dozens or hundreds, and the money will be worth a lot more to me than to forex dealers.