currency, foreign-exchangeI’ve seen a few conflicting theories on that, usually with a lot of handwaving. What’s the best current theory broadly compatible with actual data and rational expectations assumptions? (links to publicly readable research papers certainly welcome)
a carry trade is a trade where someone loans a currency with a low interest rate, exchanges it to a currency with a higher interest rate and lends it there. we shall use an example, we take a loan in US dollars where we pay 1% interest and exchange this for Brazilian Real and lend it there, we get 7% interest in brazil for that. Now the fact that a lot of people do this will weaken the US dollar to the brazilian Real ( a lot of people will exchange dollar for real, theres a large demand for real and a large supply of dollars). this Real strength will then attract more buyers and the trend is strengthened even more. however once this trend is broken for whatever reason ( a financial crisis for example) this trade will be reversed and all the money will flow out of brazil which will lead to a drop in value of the Real versus the dollar. In order to understand the way carry trades on exchange rates you have to understand the reflexivity theory in financial markets. I stated above that the carry trade is strengthening the Real and the strength of the real is attracting more buyers however if the Real was dropping in value, would this carry trade still be made? so this is a very reflexive cycle and these currency exchanges move in waves. Please do look into reflexivity theory and you will why there are conflicting theories.
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