How traders have been triumphing over economic theory
No comment on the financial markets these days is complete without mention of the “carry trade”, the borrowing or selling of currencies with low interest rates and the purchase of currencies with high rates. The trade is often blamed for the weakness of the Japanese yen and the unexpected enthusiasm of investors for the New Zealand and Australian dollars.
But why does the carry trade work? In theory, it shouldn't—or not for as long as it has. Foreign-exchange markets operate under a state of “covered interest parity”. In other words, the difference between two countries' interest rates is exactly reflected in the gap between the spot, or current, exchange rate and the forward rate. High-interest-rate currencies are at a discount in the forward market; low-rate currencies at a premium.
If that were not so, it would be possible for a Japanese investor to sell yen, buy dollars, invest those dollars at high American interest rates for 12 months and simultaneously sell the dollars forward for yen to lock in a profit in a year's time. The potential for arbitrage means such profits cannot be earned.
However, economic theory also suggests that “uncovered interest parity” should operate. Countries that offer high interest rates should be compensating investors for the risk that their currency will depreciate. In other words, the forward rate should be a good guess of the likely future spot rate.
In the real world, uncovered interest parity has not applied over the past 25 years or so. A recent academic study* has shown that high-rate currencies have tended to appreciate and low-rate currencies to depreciate, the reverse of theory. Carry-trade strategies would have brought substantial profits, not far short of stockmarket returns, although dealing costs would have limited the size of the bets traders could make.
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