The global currency tango — The relationship between the carry trade, emerging/commodity currencies and risk

Abstract

ABSTRACTThis study has foci on the global drivers of currencies and their relationship to economic jurisdiction in the presence of global risk appetite. We focus on a comprehensive basket of global currencies, deriving three statistically motivated currency market factors. We cluster on these factor loadings and find three currency groupings – Developed/European, Emerging/Commodity as well as an Asian currency cluster. Constructing ‘risk states’ based on the VIX Volatility Index, we find that Developed/European and Emerging/Commodity cluster currencies are better explained by the first three principal components when in the ‘Low’ and ‘High’ risk states respectively. As previously corroborated in the literature, we find evidence that the second principal component is a ‘carry trade factor’. We detail that the impact of this factor on currencies in the Emerging/Commodity cluster is heightened (for both positive and negative changes) by ‘High’ risk states.