Sunday, April 6, 2008

Mad Money Mankiw?

Isn't Jim Cramer as a source for mad money investment ideas enough? It appears not. Mad money investment ideas are apparently a type of disease that spreads and has reached the campus of Harvard University. Greg Mankiw, professor of economics at Harvard and author of best selling economic texts, is all hot about Carry Trade investing.

Writes Mankiw:

It is rare that I leave an economics conference with information that will change my personal financial decision making. But I was close yesterday. A fascinating discussion of a paper on the carry trade made me wonder whether I should put a little money there.

The carry trade refers to the act of borrowing from countries with low interest rates, lending to countries with high interest rates, and profiting from the interest rate differential. It is based on the hope that exchange rates will not move too much against you to wipe out the profit. In other words, it is gambling that a condition known as uncovered interest parity will not hold. In the past, this strategy has been a money-maker.

Duh! "In the past this strategy has been a money-maker." There is no dumber reason to get into an investment then because it worked in the past. Long Term Capital Management was all about trading based on things that worked in the past. It was a great strategy until things didn't work like in the past and LTCM blew up. The subprime mortgage crisis is all about default rates that didn't work like they did in the past.

Curiously, even the paper that Mankiw sites, suggests the strategy has not been a money-maker in the past:

This paper provides evidence of a strong link between currency carry and currency crash risk: investing in high interest-rate currencies while borrowing in low interest rate currencies delivers negatively skewed returns.

This certainly is downright Crameresque madness on Mankiw's part.

Oh and, by the way, given the weakness in the dollar and our expectation that the weakness will accelerate, betting against the Carry Trade by investing in the Swiss franc and the Japanese yen is the way to go.

UPDATE: Mankiw has now modified a bit the second paragraph that I quoted from his blog. But here's the real kicker, he has added to his post a chart of a "simulation" showing the Carry Trade position to work. He also added to his comment: "The above chart is a simulated past performance from the ETF's website. It is similar to some of the results shown by the discussants at the conference."

Since he still does not address the researchers (Markus K. Brunnermeier,
Stefan Nagel and Lasse H. Pedersen) findings (From the paper he sites!) that Carry Trade positions deliver "negatively skewed returns", he's just very sloppy or damn deceiving with his simulation chart.

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