When a currency trader borrows Japanese yen at 1 percent to fund the purchase of US dollar assets that yield 5 percent, the trader makes a pro…t unless the dollar depreciates. We examine how such “carry trades”can create speculative dynamics in foreign exchange markets. We develop a dynamic asset pricing model in which speculative dynamics can be ruled out in the absence of funding externalities. The additional assumption that carry traders create positive funding externalities for each other changes the nature of the price dynamics drastically. Not only does uncovered interest parity fail, but a currency with a high interest rate will exhibit the classic price pattern of “going up by the stairs, and coming down in the elevator”
To submit an update or takedown request for this paper, please submit an Update/Correction/Removal Request.