Carry Trades and Speculative Dynamics

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Abstract
When a currency trader borrows Japanese yen at 1 percent to fund the purchase of US dollar assets that yield 5 percent, the trader makes a profit even if the dollar/yen exchange rate remains unchanged. This paper examines the implications of such carry trades for speculative dynamics. In the absence of carry costs, we establish the benchmark result that speculation can be ruled out. However, carry costs can drastically change the nature of the price dynamics. Our results suggest that markets that combine significant costs of carry and low "resiliency" (such as the foreign exchange market) have the pre-conditions for large and persistent deviations of price from fundamentals, followed by abrupt reversals. Not only does uncovered interest parity fail, but a currency with a high interest rate will exhibit the classic price pattern of going up by the stairs, and coming down in the elevator.

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