Carry Trade in Emerging Markets: Return and Macroeconomic Risks

Abstract

This paper finds that currency carry trade, which is borrowing money from a low interest rate country and lending it into a high interest rate country, can generate high excess profits and high alpha in both developed and emerging markets. The profit from G-10 country carry trade is mainly from strong exchange rates, while most of the emerging markets carry trades profits are from the huge interest rate differential. Emerging market (EM) data are more favorable to the UIP hypothesis that high interest rate currency is usually depreciated, but G-10 countries are the opposite. By using quantile regression, we find that higher interest rate differential is usually associated with the exchange rate crash of the high interest rate currency. In addition, carry trade portfolios are exposed to multiple risk factors. Those factors are more significant at the low tail distribution of returns. Commodities prices and emerging market equities index positively predicted next month’s carry trade return. Liquidity condition in the U.S. is negatively related to G-10 country carry trade, but not related to emerging markets. Finally, high country risk predicted high carry trade return.