Macroeconomic Determinants of Carry Trade Activity

Carry tradespopular strategies in the foreign exchange marketare long positions in high interest rate currencies financed through funds borrowed from low interest rate currencies. It has been shown for a number of bilateral exchange rates vis-a-vis the US dollar that shocks to interest rate differentials foster carry trade activity and lead to significant changes in the foreign exchange level. This paper considers which (or which combination of) structural shocks can be consistent with the implications of such an interest rate differential shock that has been identified in previous studies. It is especially demand and confidence shocks, rather than supply or monetary policy shocks, which are found to generate effects similar to those produced by an unexpected widening of the interest rate differential and overall lead to longer-term gains from carry trade activity. Also provided is a measure of the potential gain/losses experienced by the actual positioning of market participants in the foreign exchange futures and conditional on the knowledge of the macroeconomic shock that occurred at the time of positioning.