Low volatility drives carry trade

2006 was a turbulent year, as many of the world’s major currencies fell out of synch, rising or falling by as much as 15%. Nonetheless, implied volatility (which can be calculated indirectly from currency options), fell to multi-year lows. Analysts have attributed this phenomenon to improved communication of Central Banks, a significant increase in forex trading volumes and a relatively stable global economy. As a result, the carry trade has defied the predictions of experts (including your correspondent) by remaining popular. Investors continue to borrow in Yen and Swiss Francs (with interest rates of .25% and 2% respectively) and invest in higher-yielding currencies. If the current monetary framework remains in place, this should be a profitably strategy. However, fortunes are lost as quickly as they are made, reports Reuters:

The flip side is that any gains can be quickly eroded by a rally in the funding currency -- something which is less likely to happen in markets where volatility is low.

Read More: Low FX volatility, carry trades here to stay