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The Effect Of Exchange Rate Changes On Hedge Funds' Net Asset Value

I. Introduction

According to economic theory, an investment strategy based on exploiting differences in interest rates across countries should yield no predictable profits. The economic theories that link exchange rates, price levels, and interest rates together are called international parity conditions. According to the uncovered interest rate parity (UIP), the difference in interest rates between two countries reflects the rate at which investors expect the high-interest-rate currency to depreciate against the low-interest-rate currency. According to this parity condition, one can't, on average, profit from speculating on this interest rate differential.
Puzzling however, investors seem to exploit the interest rate differential substantially, the so called carry trade. There is no generally accepted definition of what constitutes a carry trade. We define a carry trade as taking a short position in a low-interest-rate currency (funding currency) and a long position in a high(er)-interest-rate currency (target currency). Although the UIP tells us that carry trades yield no predictable profits. However, carry trades are shown to be profitable by Meese and Rogoff (1983). The authors explain that the best predictor of next month's exchange rate is today's exchange rate, which is evidence against the UIP. Even more striking, researchers (Burnside, et al, 2006) have found high-interest-rate currencies tend to appreciate against low-interest-rate currencies over short and medium time horizons, making it profitable to engage in carry trading. Carry trades do involve exchange rate risk, which should be taken into consideration. If the target currency depreciates against the funding currency before the end of a loan contract, the value of the amount initially borrowed in the funding currency will increase in terms of the target currency. This increases borrowing costs which ultimately leads to lower profitability or even losses. Therefore, exchange rate volatility is...