Carry Trade Incentives and Turbulence in the Foreign Exchange Market in Colombia

A currency carry trade is an investment strategy broadly used by speculators in which the investor sells low interest rate currencies (funding currencies) and uses the funds to invest in high interest rate currencies (target currencies). This paper analyzes if the carry‐to‐risk‐ratio estimated as the risk‐adjusted interest rate differential between Colombia and the United States is an appropriate indicator to identify opportunities in which carry trade strategies are more attractive to investors. The paper also studies if carry trades may cause large corrections in the Colombian peso/dollar exchange rate known in the literature as currency crash risk. The evidence indicates that the Colombian peso was attractive for carry trade in 2004, 2007, 2008 and 2012. Results from a vector autoregressive model also suggest that shocks to carry trade incentives may produce episodes of exchange rate turbulence.