BIS confirms continuing importance of carry trade

In the year to March 2007, low volatility and large interest rate differentials led to an increasing build-up of carry trades, the report said.

The low-yielding yen and Swiss franc were the main funding currencies for carry trades, the report confirmed. Meanwhile, the Australian and New Zealand dollars, Brazilian real, Hungarian forint and South African rand were the main targets.

“Carry trades arguably supported appreciating trends of the target currencies,” the report stated. “In May-June 2006 and February 2007, however, an unwinding of these strategies might have contributed to the weakening of the target currencies and the strengthening of the funding ones.”

The carry trade was generally profitable throughout most of 2006 and early 2007 on a risk-adjusted basis, according to the report. It said data showed yen-funded trades were particularly attractive in 2006, although the profitability of carry trades fell during periods of heightened market volatility.

The report cautioned that estimating the size of the carry trade and its impact on exchange rates is “notoriously difficult”. Nevertheless, it cited data supporting its importance from the Chicago Mercantile Exchange, foreign exchange market turnover, and a regression analysis of hedge fund returns.