New research provides a model for understanding global economic risk as it relates to a country’s main industry and export.Download the pdf
Simon assistant professor Robert Ready and two coauthors have developed the first theoretical model of this phenomenon to understand which countries are more exposed to global economic risk.
According to the authors, countries that specialize in exporting basic goods such as raw commodities tend to maintain higher interest rates, while countries that export primarily finished goods have lower interest rates on average. For investors doing currency carry trades—selling low-interest-rate currencies to buy currencies with higher interest rates—such interest rate differences “translate almost entirely into average returns,” they write.
When the world economy is doing well, basic commodities become really expensive. This causes the exchange rate to appreciate in countries that are strong raw goods exporters, such as Australia and New Zealand. In very bad times, their currencies fare poorly, making them riskier, implying that investors must be compensated with high returns to hold these currencies, Ready says.
The paper’s model provides a mechanism to explain why Australia hasn’t had a recession in 25 years, and the paper points to possible strategies for savvy investors. However, because it is rich in resources, Australia is insulated from the global risk that originates in technology-heavy regions such as Japan and Switzerland. When productivity in those areas drops, Australia can put its resources to work at home instead, insulating it from shocks in the economy.
“Sorting currencies into portfolios based on net exports of finished goods or basic commodities generates a substantial spread in average excess returns,” the authors write.
Ready coauthored the paper, “Commodity Trade and the Carry Trade: A Tale of Two Countries,” with Nikolai Roussanov of the University of Pennsylvania and Colin Ward of the University of Minnesota.