Foreign exchange risk and the predictability of carry trade returns |
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| Institution: | 1. Deutsche Bundesbank, Wilhelm-Epstein-Str. 14, 60431 Frankfurt/Main, Germany;2. Leipzig Graduate School of Management, Jahnallee 59, 04109 Leipzig, Germany;3. University of Glasgow, UK;1. Department of Accounting and Finance, University of Auckland, Auckland, New Zealand;2. TIAS Business School, Tilburg University, The Netherlands;1. Instituto de Estudios Bursátiles, Calle Alfonso XI, 28014 Madrid, Spain;2. Centro Universitario de la Defensa, Academia General Militar, Ctra Huesca s/n, 50090 Zaragoza, Spain;3. Economics Division, School of Social Sciences, University of Southampton, United Kingdom |
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| Abstract: | This paper provides an empirical investigation of the time-series predictive ability of foreign exchange risk measures on the return to the carry trade, a popular investment strategy that borrows in low-interest currencies and lends in high-interest currencies. Using quantile regressions, we find that higher market variance is significantly related to large future carry trade losses, which is consistent with the unwinding of the carry trade in times of high volatility. The decomposition of market variance into average variance and average correlation shows that the predictive power of market variance is primarily due to average variance since average correlation is not significantly related to carry trade returns. Finally, a new version of the carry trade that conditions on market variance generates performance gains net of transaction costs. |
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| Keywords: | Exchange rates Carry trade Market variance Average variance Average correlation Quantile regression |
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