Interest rate differentials can create arbitrage opportunities between countries. Carry trades
result when investors borrow in low-yielding currencies to invest in currencies with higher
interest rates. Under efficient markets and the interest rate parity (IRP) theory, carry trades
would not exist because they cannot generate positive returns since any gain in interest rate
would be offset by an appreciation of the funding currency. Any deviation from efficient
markets or the IRP allows positive expected returns and generate carry trades.
In this study, the effect of carry trades on the exchange rate volatility of emerging markets is
studied. Carry trades cause increased volatility in exchange rates but in contrast according to
other research carry traders’strategies could lead to less volatility and contributes to market
efficiency.
In our paper, the effective of carry trades on exchange rates on emerging markets exchange rates
are studied using exchange rates of Russia and Brazil. The sample period includes the recent
downturn in markets resulting from the sub-prime problems of the United States.
Emerging markets Russia and Brazil are studied because they are members of the so-called
important BRIC nations of emerging economies (China and India are not are not studied because
they have non-convertible currencies and therefore are less susceptible to carry trade volatility).
The effect of events between 2007-2009 on these two economies was very different (Dorbec and
Perracino, 2009). They responded to carry trades differently, with Russia taking a noninterventionist
approach (Financial Times (2009)) and Brazil enacting a “Tobin” tax on foreign
financial investments entering the country, and this was intended to dampen the adverse effects
of carry trades on its exchange rate (Financial Times (2009)). This study will determine what
effect, if any, the imposition of the tax had on the exchange rate and the exchange rate volatility
of Brazil.
This study uses non-stationary time series analysis to implement and test the model. The sample
period goes from January 2006 to May 2010 so that the effect of the sub-prime crisis of 2007 and
the 2009 upturn are included for study. Auto-regressions of exchange rates are examined to
measure the effect of interest rate differentials on exchange rate volatility. Structural change
tests developed by Zivot and Phillips (19XX) are used to determine if there was a significant
break in the series resulting from the sub-prime crisis or the subsequent upturn in the spring of
2009. The effect of carry trades on exchange rate volatility is measured by estimating the change
in heteroskedacticity of the auto-regression resulting from the spread of short-term interest rates
between the US and the country examined.