Abstract

The returns to carry trades are controversially discussed as there seems to be no unifying risk-based explanation of currency returns and stock returns. This paper addresses carry trade returns from a risk pricing perspective and examines if these returns can be connected to persistent cross-country differences of risk aversion. Therefore, I analyze a data set of individual carry trade currencies. Based on a GMM estimation, I find significantly large and persistent cross-country differences of risk aversion in the interest rate market compared to the implied risk aversion in the stock market. In this context, investment currencies are more sensitive to U.S. consumption risk while funding currencies provide a hedge. However, this also implies that there is no unifying SDF and consequently, both the interest rate market and the stock market appear to be segmented in risk pricing for carry trade countries.

Highlights

  • Carry trade strategies show a persistent outperformance compared to a passive benchmark strategy, even on a risk-adjusted basis, and appear to be unrelated to traditional risk factors (Burnside, 2011a; Byrne et al, 2018)

  • This paper addresses carry-trade returns from a risk pricing perspective and contributes to the literature of proposed differences in risk pricing and heterogeneous risk aversion by an empirical analysis

  • A higher risk aversion for countries of investment currencies (e.g., Australia) in the interest rate market compared to the implied risk aversion can be observed in the sample

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Summary

Introduction

Carry trade strategies show a persistent outperformance compared to a passive benchmark strategy, even on a risk-adjusted basis, and appear to be unrelated to traditional risk factors (Burnside, 2011a; Byrne et al, 2018). Carry-trade portfolio returns exhibit a lower negative correlation to global foreign exchange volatility, which is not significant at the five percent level, and. This is consistent with the findings of Burnside et al (2011) and Menkhoff et al (2012), where carry-trade portfolio returns appear to be unrelated to traditional risk factors It supports the conclusion drawn by Byrne et al (2018) that, based on the larger pricing error of stock market downside risk as compared to a common (carry trade) risk factor, currency and stock markets are not completely integrated, which will be quantified in the two sections. It can be inferred that the correlation in the short-term interest rate structure is high while the maturity premium appears not to differ substantially

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