The Carry Trade and The Adjustment of the Japanese Yen : Evidence from a Markov-Switching Vector Autoregression Model

Carry trades are speculative activities which involve simultaneously going short a low-rate currency and long a high-rate currency. They are profitable as long as the gains from interest rate differentials are not offset by exchange rate movements. In this paper I investigate the dynamic relationships amongst exchange rate changes, interest rate spreads and carry trades by means of a Markov-switching vector autoregression model. I use regime-dependent impulse response functions to assess (1) how and to what extent shocks to the interest rate differential and the bilateral exchange rate affect the yen carry trade; (2) the consequences of the unwinding of the yen carry trade on the dollar-yen exchange rate. Empirical evidence indicates the presence of a so-called “carry trade” regime, whose timing is consistent with the yen carry trade episodes identified in the literature. Moreover, only when the system is in the “carry trade” regime a shock in the carry-to-risk ratio has a positive and significant effect on the net short positions in Japanese yen and the depreciation of the yen against the dollar is strong and persistent. Finally, a rising carry-to-risk ratio, which in turn reveals an increase in the attractiveness of carry trades, leads to a significant depreciation of the yen only when the system is in the “carry-trade” regime