Research question:
The main research question: "How does the carry trade strategy work?" is focused on a basic explanation of the carry trade strategy. This question is answered in chapter four including the risk and profitability of carry trades.
The sub-question is: "What is the theoretical background?" This question is focused in chapter two, chapter three and the beginning of chapter four. Chapter seven summarizes this paper and gives the answer if someone should invest money by using this strategy.
Table of Contents
1 Problem outline and significance
1.1 Purpose and Motivation
1.2 Research question
1.2 Methodology
1.3 Disposition
1.4 Terminology
2 Foreign Exchange Markets
2.1 Characteristics of the Foreign Exchange Market
2.2 Efficient Market Hypotheses
3 International Parity Relationships
3.1 Parities
3.2 Interest Rate Parity
3.3 Purchasing Power Parity
3.4 Unbiased Forward Rate
3.5 Fisher Effect
3.6 International Fisher Effect
4 Carry Trade Strategy
4.1 Forward Premium Puzzle
4.2 Explanation of the Carry Trade Strategy
4.3 Risk and Profitability of the Carry Trade Strategy
5 Data set and explanation of the case study
5.1 Assumptions
5.2 Foreign Exchange Rate
5.3 Money Market Rate
5.4 Spread Sheet for Carry Trade Strategy and its Results
6 Fundamental law of Active Management
6.1 Active Return
6.2 Active Risk
6.3 Information Ratio
7 Conclusion and critical acclaim
Objectives and Research Themes
This paper aims to explain the mechanics of the carry trade strategy and its theoretical foundation, specifically analyzing international parity relationships. Through a simulated case study using data from CEE countries and Turkey between 2003 and 2009, the research evaluates the profitability and associated risks of this investment approach, while investigating whether the exclusion of high-loss currencies could optimize returns.
- Theoretical analysis of foreign exchange markets and efficient market hypotheses.
- Examination of international parity relationships including Interest Rate Parity and the Fisher Effect.
- Empirical simulation of a currency carry trade strategy.
- Performance evaluation using the Fundamental Law of Active Management and Information Ratio.
- Assessment of risks related to exchange rate volatility and interest rate variations.
Excerpt from the Book
4.2 Explanation of the Carry Trade Strategy
The term “carry” generally stands for the difference between the income from a security (or portfolio) and the corresponding financing costs. The carry trade in currencies is an active investment strategy whereby an investor borrows funds in a low interest currency in order to lend it in a high interest rate currency, while neglecting potential exchange rate movements, which should, if arbitrage were perfect, offset the interest rate differential. “With this strategy, the borrowed funds are converted in the spot market and invested in securities of a high-yielding currency. At the end of the holding period, the equivalent of the borrowed amount is converted in the spot market back to the funding currency to repay the loan.”
“On average the investor would expect to make zero profits if uncovered interest rate parity held, because the interest differential would reflect the expected depreciation of the high interest rate currency against the low interest rate currency.”
The key underlying determinant of carry trade profitability is the forward premium (or discount) puzzle or the failure of uncovered interest parity. If this condition holds, the currency with a low interest rate is expected to appreciate relative to the currency with the high interest rate. So the movements in the exchange rate would reduce the gains from investing in the higher yielding currency. But extensive research has shown that this condition is violated, at least in the short run and may hold in the long run.
Summary of Chapters
1 Problem outline and significance: Introduces the research motivation regarding the global foreign exchange market turnover and outlines the core objective of simulating the carry trade strategy.
2 Foreign Exchange Markets: Defines the characteristics of global currency markets and discusses the Efficient Market Hypothesis in its weak, semi-strong, and strong forms.
3 International Parity Relationships: Explains the theoretical framework connecting exchange rates, interest rates, and inflation, including Interest Rate Parity and the International Fisher Effect.
4 Carry Trade Strategy: Outlines the empirical basis of the carry trade via the forward premium puzzle and details the mechanics and risk profile of the strategy.
5 Data set and explanation of the case study: Presents the methodology for the simulation, including data sources, currency pool selection (CEE states and Turkey), and the spread sheet construction process.
6 Fundamental law of Active Management: Applies quantitative portfolio management metrics, such as active return, active risk, and the information ratio, to evaluate the performance of the carry trade case study.
7 Conclusion and critical acclaim: Summarizes the findings of the simulation, concluding that while profitable over the long term, the strategy involves significant risks not suitable for short-term investors.
Keywords
Carry Trade, Foreign Exchange, Interest Rate Parity, Efficient Market Hypothesis, CEE States, Currency Simulation, Forward Premium Puzzle, Active Management, Information Ratio, Exchange Rate Volatility, Asset Pricing, Financial Markets, Risk Management, Quantitative Finance, Investment Strategy.
Frequently Asked Questions
What is the primary focus of this seminar paper?
The paper focuses on the theoretical background and practical simulation of the carry trade strategy specifically within CEE countries and Turkey.
What are the central thematic areas?
Key areas include foreign exchange market characteristics, international parity relationships, the forward premium puzzle, and active investment management.
What is the primary research question?
The central question addressed is "How does the carry trade strategy work?" coupled with the sub-question regarding its theoretical background.
Which scientific methods are employed?
The paper uses literature research for the theoretical sections and a case study simulation using MS-Excel to analyze Bloomberg and Reuters data.
What is covered in the main section?
The main section covers the conceptual framework of parity relationships, the explanation of carry trade mechanics, and a detailed performance simulation including active risk metrics.
Which keywords best characterize this research?
Relevant keywords include Carry Trade, Information Ratio, Interest Rate Parity, and Efficient Market Hypothesis.
Why was Turkey included in the CEE-focused study?
Because the European currency union was enlarged, the pool of CEE currencies was limited, so the author included Turkey to expand the scope of the case study.
How does the author evaluate the "Information Ratio" in this context?
The information ratio is used to assess the manager's ability to add value relative to the taken risk in the simulation, comparing strategies with and without the Czech crown.
- Citar trabajo
- Mag.(FH) Carina Wechtl (Autor), 2011, Theoretical Background and Simulation of the Carry Trade Strategy within CEE-States, Múnich, GRIN Verlag, https://www.grin.com/document/186779
