Time-Varying Risk Aversion and the Profitability of Carry Trades: Evidence from the Cross-Quantilogram

Riza Demirer,Hossein Hassani,Xu Huang,Rangan Gupta

doi:10.3390/economies8010018

Riza Demirer, Hossein Hassani + Show 2 more

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https://doi.org/10.3390/economies8010018

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Abstract

This paper examines the predictive power of time-varying risk aversion over payoffs to the carry trade strategy via the cross-quantilogram methodology. Our analysis yields significant evidence of directional predictability from risk aversion to daily carry trade returns tracked by the Deutsche Bank G10 Currency Future Harvest Total Return Index. The predictive power of risk aversion is found to be stronger during periods of moderate to high risk aversion and largely concentrated on extreme fluctuations in carry trade returns. While large crashes in carry trade returns are associated with significant rises in investors’ risk aversion, we also found that booms in carry trade returns can be predicted at high quantiles of risk aversion. The results highlight the predictive role of extreme investor sentiment in currency markets and regime specific patterns in carry trade returns that can be captured via quantile-based predictive models.

Highlights

Carry trade strategies aim to exploit deviations from the uncovered interest parity by investing in currencies that yield high interest rates and funding these positions by borrowing low-yielding currencies. Christiansen et al (2011) note that the popularity of carry trades largely stems from the fact that the average carry trade strategy outperforms individual currency returns, while it offers lower return volatility compared to individual currencies
Economies 2020, 8, 18 while carry trade crashes tend to occur when risk appetite decreases and funding conditions tighten (Brunnermeier et al 2009). We extend these discussions in a novel direction by examining the predictability of payoffs to carry trades by means of the recently developed time-varying risk aversion index of Bekaert et al (2017), which has been shown to contain significant predictive information over gold market volatility (Demirer et al 2019), an asset that is often considered a traditional hedge against market crashes
Utilizing daily data for the Deutsche Bank G10 Currency Future Harvest Total Return Index to track the performance of a typical carry trade strategy, we show that risk aversion captures predictive information over payoffs to the currency carry trade strategy

Summary

Introduction

Carry trade strategies aim to exploit deviations from the uncovered interest parity by investing in currencies that yield high interest rates and funding these positions by borrowing low-yielding currencies. Christiansen et al (2011) note that the popularity of carry trades largely stems from the fact that the average carry trade strategy outperforms individual currency returns, while it offers lower return volatility compared to individual currencies. Christiansen et al (2011) note that the popularity of carry trades largely stems from the fact that the average carry trade strategy outperforms individual currency returns, while it offers lower return volatility compared to individual currencies Despite their impressive risk-adjusted returns, these highly popular, speculative strategies are often exposed to severe crashes (e.g., Burnside et al.2007; Brunnermeier et al 2009), due to their high exposure to crash risks driven by funding constraints (Brunnermeier et al 2009) or illiquidity risks (Plantin and Shin 2011). The use of this recently proposed index in this context allows enlarging our understanding of the role of changes in risk preferences over the profitability of speculative trading strategies in the currency market

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