Carry trades are transactions in which a low-interest funding currency is borrowed to invest in assets in a higher-interest destination currency without hedging for currency risk. They raise both macroeconomic and financial stability concerns because they may contribute to extended periods of currency appreciation followed by sudden currency declines.
In Latin America the three main ways to implement carry trades are reportedly: (i) purchasing debt denominated in the destination currency, as observed in a number of Latin American countries; (ii) taking a long position in the destination currency in the (deliverable) swap market, as seen in Mexico; and ( iii ) taking a long position in the non-deliverable forwards market, as practised in a number of countries in South America. Derivatives positions may be priced so as to earn returns similar to those from purchasing debt denominated in the destination currency. Arbitrage and other trades are also an important motivation for crossborder portfolio investments.
Regulations and market characteristics influence the types of international portfolio investor (ie hedge fund, real money or domestic corporates), their portfolio investment strategies (spot or derivatives markets, deliverable or non-deliverable, extent of hedging etc), and their domestic counterparties. For example, regulations that limit or increase the cost of foreign access to domestic financial markets appear to have encouraged the development of offshore non-deliverable forward foreign exchange markets in the region. Foreign exchange policy (ie intervention) can also influence carry trades. Regulations and taxes have played an important role in the types of market used by foreign investors.
Consultations with the private sector suggest that narrower interest rate differentials have reduced the profitability of carry trade positions. The attractiveness and feasibility of carry trades have been further impaired by the reduced availability of financing for risky leveraged positions, in part due to changes in regulation in the aftermath of the global financial crisis. As a result, in recent years, real money investors who rely less on leverage and who have longer investment horizons have reportedly played an expanded role in cross-border portfolio investment. At the same time, the relative importance of hedge funds has reportedly declined, as has the use of carry trades as an investment strategy.
Capital inflows and reversals pose a number of challenges for monetary authorities in emerging market economies (EMEs). Among the various types of capital flow, currency carry trades raise particular concerns because they may be destabilising: carry trades may contribute to extended periods of currency appreciation, moving and keeping the real exchange rate away from its fundamental equilibrium, and thus eroding competitiveness. Currency carry trades may also be associated with currency crash risks because, in their typical form, they are funded mostly by debt. A shock that produces losses can be amplified by so-called liquidity spirals. Speculators facing funding constraints will close out their positions, further undercutting prices, which can lead to further tightening of funding constraints and close-outs. Recent studies (Brunnermeier and Pedersen (2009); Brunnermeier, Nagel and Pedersen (2009)) provide a theoretical framework and supporting evidence.