The latest quarterly review published this week by the Bank for International Settlements in Basle featured an examination of carry trades (http://www.bis.org/publ/qtrpdf/r_qt0709.htm). “Low exchange rate volatility and persistent interest rate differentials have underpinned significant cross-currency positioning in recent years. These positions have often taken the form of currency carry trades, or leveraged cross-currency trading strategies....The effect of carry trade activity on exchange rates is typically asymmetric, and can be significant. The build-up of these positions generally contributes to a steady strengthening of target currencies (associated with high interest rates) and a weakening of funding currencies....when changes in interest rate expectations or volatility lead to a sudden unwinding of carry trades, there is a tendency for target currencies to depreciate and funding currencies to appreciate sharply,” BIS writes.
“Perhaps the best known example is the sharp appreciation of the yen against the US dollar between 6 and 8 October 1998, following a prolonged period of depreciation. This was the sharpest move in major foreign exchange rates since 1974 and was accompanied by a significant spike in volatility: One-month implied volatility reached 40% and bid-ask spreads widened markedly. Market analysts explained the move in terms of a sudden, massive reversal of carry trade positions, despite the lack of an apparent trigger,” it adds.