Commodity Trade and the Carry Trade: A Tale of Two Countries

Persistent differences in interest rates across countries account for much of the profitability of currency carry trade strategies. The high-interest rate \investment" currencies tend to be "commodity currencies," while low interest rate "funding" currencies tend to belong to countries that exportnished goods and import most of their commodities. We develop a general equilibrium model of commodity trade and currency pricing that generates this pattern via frictions in the shipping sector. The model predicts that commodity-producing countries are insulated from global productivity shocks by the limited shipping capacity, which forces thefinal goods producers to absorb the shocks. As a result, a commodity currency is risky as it tends to depreciate in bad times, yet has higher interest rates on average due to lower precautionary demand, compared to the final good producer. The model's predictions are strongly supported in the data. The commodity-currency carry trade explains a substantial portion of the carry-trade risk premia, and all of their pro-cyclical predictability with commodity prices and shipping costs, as predicted by the model.

Back to overview