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Strategies & Market Trends : The Epic American Credit and Bond Bubble Laboratory -- Ignore unavailable to you. Want to Upgrade?

To: russwinter who wrote (69312)	9/4/2006 6:24:37 PM
From: YanivBA	Respond to of 110194

I found a good paper on the carry trade. The fundamental question is how come carry traders consistently make money. Is this a free lunch? faculty.haas.berkeley.edu This paper found a way to separate the movements in the exchange rate that are due to the interest rate differential and all the rest of the movement. The key was to know that interest is incurred each day on 17:00 New York time. So what they did is to separate the time around the interest payment from the rest of the movement. It turns out that there are no gains for the carry trade around the interest payment, which means that any interest paid is immediately offset by the movement of the exchange rate against the carry trade. The carry trade gains only come during the trading day. This indicates that the gains that are made on the carry trade have nothing to do with interest rate differentials. The gains have everything to do with the risk that the interest rate differential is associated with. Carry traders are compensated for the extra risk they assume because the high interest currency is usually more risky. This is much like stock holders, corporate bond holders and option sellers are compensated, in the long term, for the risk they assume. Another implication is that generally the carry trade is a sound trade. Of course if it becomes overcrowded (like now when it makes the news every other day) the downside could be greater than the upside. But after it breaks and people forget... YanivBA.