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Carry Trading & Uncovered Interest Rate Parity Carry Trading & Uncovered Interest Rate Parity - An overview and empirical study of its applications M.Westman F.Tafazoli 2011 Carry Trading & Uncovered Interest Rate Parity - An overview and empirical study of its applications Bachelor thesis Linköping University VT 2011 Authors: Mathias Westman & Farid Tafazoli Abstract. The thesis examine if the uncovered interest rate parity holds over a 10 year period between Japan and Australia/Norway/USA. The data is collected between February 2001 - December 2010 and is used to, through regression and correlation analysis, explain if the theory holds or not. In the thesis it is also included a simulated portfolio that shows how a carry trading strategy could have been exercised and proof is shown that you can indeed profit as an investor on this kind of trades with low risk. The thesis shows in the end that the theory of uncovered interest rate parity does not hold in the long term and that some opportunities for profits with low risk do exist. Uppsatsen undersöker om det icke kurssäkrade ränteparitetsvilkoret har hållit på en 10-års period mellan Japan och Australien/Norge/USA. Månadsdata från februari 2001 till december 2010 används för att genom regressionsanalys samt undersökning av korrelationer se om sambandet håller eller inte. I studien finns också en simulerad portfölj som visar hur en carry trading portfölj kan ha sett ut under den undersökta tidsperioden och hur man kan profitera på denna typ av handel med låg risk. Studien visar i slutet att teorin om det kursosäkrade ränteparitetsvilkoret inte håller i det långa loppet och att vissa möjligheter till vinst existerar. Keywords: Uncovered Interest Rate Parity, Australian Dollar, Norwegian Kronor, US Dollar, Japanese Yen, Carry Trading. 1 2011-05-26 Table of Contents Cover page ............................................................................................................................. 1 Foreword ................................................................................................................................ 4 1. Background ...................................................................................................................... 5 1.1 Introduction ................................................................................................................... 5 1.2 Problem area ................................................................................................................ 5 1.3 Formulation of the problem ........................................................................................... 6 1.4 Limitations ..................................................................................................................... 6 2. Methodology ..................................................................................................................... 7 2.1 Scientific approach ........................................................................................................ 7 2.2 Research approach ....................................................................................................... 8 2.3 Collection of data .......................................................................................................... 8 2.4 Research methods ........................................................................................................ 9 2.5 Research directions .....................................................................................................10 2.6 Analyzing the research .................................................................................................10 2.7 Method critiques ...........................................................................................................11 2.8 Choice of countries, time-periods and interest rates .....................................................11 2.9 Source critique .............................................................................................................12 3. Theory ..............................................................................................................................13 3.1 Uncovered interest rate parity ......................................................................................13 3.2 Linear regression .........................................................................................................15 3.3 Problems with the regression methods .........................................................................15 3.4 Forex & Interest rate risks ............................................................................................16 3.5 Currency spot rate........................................................................................................16 3.6 Treasury bills & Zero-Coupon Bonds ...........................................................................16 3.7 Arbitrage ......................................................................................................................17 3.8 Carry trading ................................................................................................................18 3.9 Earlier studies ..............................................................................................................19 4. Empirical ..........................................................................................................................20 4.1 Regressions .................................................................................................................20 4.2 Simulated portfolio .......................................................................................................25 2 2011-05-26 5. Analysis ...........................................................................................................................28 5.1 Analysis of the regressions ..........................................................................................28 5.2 Carry trading portfolio ...................................................................................................30 6. Discussion .......................................................................................................................36 7. Closing words ..................................................................................................................37 8. References .......................................................................................................................38 8.1 Literature ......................................................................................................................38 8.2 Electronic references ...................................................................................................39 9. Appendix ..........................................................................................................................40 9.1 Data .............................................................................................................................40 3 2011-05-26 Foreword The ultimate dream for every investor has always been the perfect arbitrage opportunity. Something that would provide you with high returns with low or no risk at all, preferably over longer periods of time. For some investors, especially hedge funds and institutional investors, carry trading is just that opportunity. In this thesis we aim to shed some light on this relatively unknown, at least for the common investor, kind of currency exchange and interest rate trading and show how it is possible for anyone to profit from this. Mathias Westman & Farid Tafazoli - Linköping, Sweden 2011 4 2011-05-26 1. Background In this chapter we present why carry trading is an interesting phenomenon to investigate further. We also present the purpose and problem area for the thesis. 1.1 Introduction For a long time, investors around the world have used a trading strategy that very simplified means that you borrow money in a country with low interest rate and invest this amount in one where the interest rate is higher. The countries’ different interest rates should, as the Uncovered Interest rate Parity (from here on UIP) states it, affect the value of the countries’ currencies. This should remove all chances of arbitrage opportunities as currencies appreciate and depreciate. As we are about to show, the UIP theory has not held up and as a result, U.S. hedge funds and other investors worldwide have been able to make profits at a low risk. We choose to write this thesis on this subject since both the authors have great interest in both the currency and interest rate markets and this subject covers both of them. It is also a good way to get acquainted with central theories in two of the most important markets in today’s financial world. 1.2 Problem area When doing investments with carry trading models there is an interest rate differential risk and there is also an exchange rate risk. Both of these parameters are included in the Uncovered Interest rate Parity model. Many carry trading investors have through out the last two decades chosen Japan as the country to borrow money in because of the low held interest rate due to their long term economic problems. The Japanese central bank has held the interest rate as low as zero or close to zero per cent during this time. Countries such as Australia and New Zeeland have on the other hand been countries that investors have been looking to invest in due to their high interest rate during a long period of time. This difference in interest rate should
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