Abstract - Carry Trades and Speculative Dynamics

We develop a model of foreign exchange trading with imperfect liquidity. Speculators have a collective impact on market liquidity. Moreover, their margin requirements decrease with market liquidity. Such circumstances can turn carry trades into self-enforcing arbitrage opportunities: Carry trades generate all the more value because many speculators enter them. As a result, rational speculation destabilizes the exchange rate. Applying recent advances in dynamic coordination games, we obtain a unique equilibrium exchange rate with high conditional skewness. Namely, extended periods of slow depreciation of the low rate currency are followed by abrupt reversals. Reversals are stochastic, but their distribution is uniquely determined by the distribution of the fundamentals.

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