Discussion Paper Series 2014-E-14

Destabilizing Carry Trades

Guillaume Plantin, Hyun Song Shin

We offer a model of currency carry trades in which carry traders earn positive excess returns if they successfully coordinate on supplying excessive capital to a target economy. The interest-rate differential between their funding currency and the target currency is their coordination device. We solve for a unique equilibrium that exhibits the classic pattern of the carry-trade recipient currency appreciating for extended periods, punctuated by sharp falls.

Keywords: currency carry trades; inflation targeting; financial instability

Views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.

Copyright © 2014 Bank of Japan All Rights Reserved.

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