DIE 01-26 Carry Trade and Exchange Rate Dynamics: The Case of Uruguay

The currency carry trade strategy is based on investing in assets denominated in a currency with a relatively high interest rate, financed with debt in a currency with a lower interest rate. Changes in demand for domestic currency associated with carry trade operations generate periods of gradual appreciations followed by sudden depreciations. This study shows evidence supporting that these dynamics take place for the USD/UYU exchange rate during the most recent period in which the interest rate has been used as the monetary policy instrument. Subsequently, through an innovative approach to estimating the carry-to-risk ratio, used as a proxy for carry trade incentives, I show that there is a positive relationship in this period between the demand for peso-denominated instruments and the incentives for carry trade. This evidence supports the view that carry trade operations help explain the negative relationship between the interest rate differential and both the mean and the variance of the exchange rate. These findings are relevant given the possibility of sudden depreciations that such dynamics can trigger, which the central bank could mitigate through timely intervention.

Keywords: Carry trade; Carry-to-risk ratio; Exchange rate dynamics; Interest rate differential.