Couple of weeks back, I wrote about how hedge funds are propping up the price of oil. Now come s a paper from Princeton on Carry trades and Currency Crashes, by Markus K. Brunnermeier, Princeton, Stefan Nagel, Stanford and Lasse H. Pedersen, NYU, raises some curious questions about a possible snowball building up for certain currencies. Hat tip to the Professor, who also has a very nice explanation for Carry Trades.

The carry trade refers to the act of borrowing from countries with low interest rates, lending to countries with high interest rates, and profiting from the interest rate differential. It is based on the hope that exchange rates will not move too much against you to wipe out the profit. In other words, it is gambling that a condition known as uncovered interest parity will not hold.

Now this is not a problem in itself. The problem comes when a currency starts moving due to the unwinding of carry trades. This is one part the Princeton paper focuses on.

Another puzzling feature of currencies is that dramatic exchange rate movements occasionally happen without fundamental news announcements, e.g. the large depreciation of the US Dollar against the Japanese Yen on October 7th and 8th of 1998, depicted in Figure 1.1 This reflects the broader phenomenon that many abrupt asset price movements cannot be attributed to a fundamental news events, as documented by Cutler and Summers (1989) and Fair (2002). We conjecture that sudden exchange-rate moves unrelated to news can be due to the unwinding of carry trades when speculators near funding constraints.

And then they go on to support this conjecture with their findings. Simple translation - Carry traders borrow at low rates in currencies like the Japanese Yen and invest in higher yield assets such as US or emerging market debt. The risk, as happened in the US with the mortgage crisis, is that these carry traders may run out of liquidity to sustain the large transactions, and end up reversing, or unwinding, their trades. Which means that the large amount of currency they acquired goes back to the lending country, thus adding to the devaluatory pressure on an already undervalued currency. If a sufficiently large number of carry traders were to jump ship at the same time, it could even trigger an economic crisis of epic proportions, with an inflation surge and ordinary investors jumping ship.

An article in MoneyWeek by Jeremy Batstone, Director of Private Client Research at Charles Stanley, titled The carry trade: A tsunami in the making, further explores these very risks. The article is given further weight by the fact that it was published in early 2007, preceded by an article which predicted a shock of seismic proportions to the financial markets caused by indigestion stemming from the swathe of debt-funded acquisitions. We all know how that turned out, so if I were you, I'd sit up and pay attention to the risk of carry trades.