Carry Trades in Emerging Markets

John FO Bilson

Following the global financial crisis, the central banks of the developed world all pursued policies of quantitative easing that reduced shortterm interest rates to levels near zero. One by-product of this policy has been that the profitability of the carry trade – a strategy of borrowing low-yield currencies and investing in high-yield currencies – has been diminished in the markets of developed countries. However, opportunities for carry-trade strategies have actually expanded in developing markets as countries have opened their capital markets and their currencies to external traders. In this chapter, the profitability of EM carry trades is explored. The chapter has the following objectives. First, since the number of traded instruments is large when considering the EM, the traditional mean-variance approach could be replaced by a more parsimonious factor model for position selection. Second, the chapter recognises that market conditions do not always support the carry-trade strategy. We model the bull and bear market environments using a static mixture of a normal model and a dynamic Markov switching model, the results demonstrating that dynamic switching models are preferable