Self-fulfilling and self-destructing FX carry trades

November 2, 2014

When foreign exchange trading meets inflation-targeting self-fulfilling investment strategies are possible. A technical paper by Plantin and Shin shows that positive FX carry encourages capital inflows that reduce inflation and allow monetary policy to condone a domestic asset market boom. Thereby FX carry strategies create their own implicit subsidy and self-validating flows. Conversely, a reversal of such flows is self-destructing.

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Disaster risk and currency returns

November 1, 2014

A paper by Farhi and Gabaix explains how fear of global crisis leads to outperformance of risky versus less risky currencies. Carry trades have worked historically, because high risk premia conditioned both high interest rates and subsequent revaluation. As a practical conclusion, gaps between perceived risk (often based on historical variances and correlation) and actual fundamental risk (as indicated by fundamental macro factors) are key value generators in FX strategies.

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Some stylized facts of FX liquidity

October 28, 2013

A paper of the University of St. Gallen shows that foreign exchange liquidity has been highly correlated across currency pairs, apparently more so than in equity markets. Liquidity correlation has been strongest in developed FX markets and particularly in volatile currency pairs. Bond and equity markets seem to have a bearing on systematic FX liquidity. Feedback loops between market illiquidity and funding constraints can escalate into fire sales. Riskier currency pairs, and particularly those related to carry trades, are more susceptible to liquidity shocks.

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