The Carry Trade Carries On

LONDON – The Bank for International Settlements recently reported that $4 trillion a day is traded in global foreign-exchange (FX) markets, up from $3.3 trillion in 2007. But, while the size of the FX business always grabs headlines, the way that currencies are traded also matters – and this has evolved mightily over the years.

Any introductory finance textbook will tell you that investors care about the returns of their overall portfolio, not just its individual assets. Investors prize assets that are relatively uncorrelated, or even better, negatively correlated with the returns of the market as a whole. Owning such assets tends to stabilize overall returns.

That is fine in theory, but where do such assets come from? Some stock prices are normally relatively uncorrelated with the market. But stock prices tend to move much more closely together at times of market dislocation. So the relationship is liable to go wrong at the worst possible time: when a hedge would be most useful, the asset you were relying on becomes a risk.

Many financial derivatives were developed for exactly this reason – to allow both financial and non-financial companies to hedge their overall returns. But not all investors are able to trade derivatives.