Carry Trade Risk Research Articles

The effect of COVID-19 vaccine on the international financial markets

Existing studies on the COVID-19 pandemic and vaccine development have primarily documented their effects on stock markets, with limited attention to international financial markets. This paper constructs a news-based sentiment index on COVID-19 vaccine development and examines its effects on international financial markets during the first year of the pandemic. We find positive vaccine sentiment decreases the CBOE Volatility Index (VIX) while boosting capital inflows and currency appreciation in emerging markets. It also reduces the unit price of risk in the context of carry trade risk premiums, as positive developments lower future risk and economic uncertainty.

Political risks, excess and carry trade returns in global markets

We re-examine the relationship between exchange rates and sovereign risk and provide evidence that sovereign risk affects advanced economies and emerging markets differently. Also, double-sorting 34 currencies from developed and emerging economies into different portfolios based on the level of macro risk and political risk, we provide evidence that local determinants of sovereign risk are priced in the FX markets. Local political risk in particular seems to have become an important carry trade risk factor in the post-2007 financial crisis era. High macro risk portfolios in the presence of high political risk lead to higher excess returns. Our results are robust across country categories and currency regimes, with stronger results for emerging economies. This is one of the few papers to examine how the local components of sovereign risk, rather than the systematic risk component, drive currency carry trade returns. We contribute a fresh perspective that supports the risk-based view on the UIP puzzle.

Sovereign default network and currency risk premia

We construct a sovereign default network by employing high-dimensional vector autoregressions obtained by analyzing connectedness in sovereign credit default swap markets. We develop four measures of centrality, namely, degree, betweenness, closeness, and eigenvector centralities, to detect whether network properties drive the currency risk premia. We observe that closeness and betweenness centralities can negatively drive currency excess returns but do not exhibit a relationship with forward spread. Thus, our developed network centralities are independent of an unconditional carry trade risk factor. Based on our findings, we develop a trading strategy by taking a long position on peripheral countries’ currencies and a short position on core countries’ currencies. The aforementioned strategy generates a higher Sharpe ratio than the currency momentum strategy. Our proposed strategy is robust to foreign exchange regimes and the coronavirus disease 2019 pandemic.

Dollar Carry Timing

Dollar carry trade risk premiums - unlike dollar-neutral or foreign exchange carry risk premiums - are positively correlated with firm-level dispersions in investment, profitability, and book-to-market in addition to the Treasury-bill rate, long term bond yield, term spread, and default spread. This predictability is also statistically and economically significant out of sample: It generates Sharpe ratios as large as 1.37 (compared to 0.44 unconditionally), for example. Indeed, several forecasting models pin down the few periods responsible for the entire premium. Finally, any detailed narrative (typically based on untestable claims) in which the variables above are proxies for the latent (quantity of) risk and price of risk states - and the business cycle - in the U.S. explains the results in the present paper. However, I avoid making this type of less scientific claims as much as possible and focus on the evidence, instead.

Dollar Carry Timing

Dollar carry trade risk premiums – unlike dollar-neutral or foreign exchange carry risk premiums – are positively correlated with firm-level dispersions in investment, profitability, and book-to-market in addition to the Treasury-bill rate, long term bond yield, term spread, and default spread. Several forecasting models pin down the few periods responsible for the entire premium, based on these proxies for the latent risk and price of risk states in the U.S. (and its business cycle). This predictability is also statistically and economically significant out of sample: It generates Sharpe ratios as large as 1.37 (compared to 0.44 unconditionally), for example.

Common information in carry trade risk factors

Carry returns have been widely observed in the FX market. This study exploits the common information embedded in several factors previously identified as relevant to carry trade returns. We find that the extracted common factor successfully models the time series and cross-sectional characteristics of carry returns. Empirical evidence is presented that the common factor produces smaller pricing errors than other well known factors, such as innovations of exchange rate volatility and the downside stock market excess return. Our results also suggest that stock market risk is somewhat segmented from FX market risk.

Option-implied volatility spillover indices for FX risk factors

This study employs option price data to back out the implied portfolio volatilities of the dollar and carry trade risk factors of the G-10 currencies. We construct a forward-looking option-implied volatility spillover index. Our findings indicate that the dollar and carry trade risk factors are orthogonal in the first moment and exhibit strong stochastic interrelations in the second expected moment.

Fundamental Indexing in Global Bond Markets: The Risk Exposure Explains It All

To investigate the fundamental indexing methodology, I apply it to global government bond markets and examine its exposure to several newly introduced risk factors. I find that the fundamental indexing approach outperforms a market-value-weighted index. However, my results show statistically significant and economically relevant exposures of fundamentally weighted indexes to the risk factors term and duration risk, default risk, convexity risk, liquidity risk, and carry trade risk. The increased risk exposure explains the outperformance of the fundamental indexing methodology in government bond markets.

Common Information in Carry Trade Risk Factors

Carry returns have been widely observed in the FX market. This study exploits the common information embedded in several factors previously identified as relevant to carry trade returns. We find that the extracted common factor successfully models the time series and cross-sectional characteristics of carry returns. Empirical evidence is presented that the common factor produces smaller pricing errors than other well known factors, such as innovations of exchange rate volatility and the downside stock market excess return. Our results also suggest that stock market risk is somewhat segmented from FX market risk.

Exchange Rates, Carry Trade Returns and Political Risks

This paper elucidates the channels through which sovereign risk, exchange rates and currency risk premia are related. I show that the channels are different depending on whether a country is classified as emerging or an advanced economy. Generally, for emerging market economies, local sovereign risk factors, namely country-specific political risk and macroeconomic risk do play a significant role in the depreciation of the local currency relative to the U.S. dollar. Whilst there is no convincing evidence that local determinants of sovereign risk cause a depreciation of currencies of advanced economies before the 2007 financial crisis, I do find that political risk does matter for advanced economies in the post-crisis era. For both sets of economies, global factors also play an important role in the relationship between sovereign risk and exchange rates. Secondly, double-sorting 34 currencies into different portfolios based on the level of macro risk and political risk, I provide evidence that local determinants of sovereign risk are priced in the FX markets, i.e. they can forecast currency carry trade excess returns in the cross-section. Local political risk in particular seems to have become an important carry trade risk factor in the post-2007 financial crisis era. This is the first research to explain carry trade excess returns with local sovereign risk factors as against sovereign risk as a whole.

The Carry Trade and Implied Moment Risk

The carry trade is a zero net investment strategy that borrows in low yielding currencies and subsequently invests in high yielding currencies. It has been identified as highly profitable FX strategy delivering significantly excess returns with high Sharpe ratios. This paper shows that these excess returns are especially compensation for bearing FX variance and negative skewness risk. Additionally, factor risks that affect foreign money changes, foreign inflation changes, as well as changes to a newly developed Carry Trade Activity Index and the VIX index, as a proxy for global risk aversion, make up the carry trade risk anatomy. These findings are not exclusively important for carry traders, but also contribute to the understanding of currency risk in the cross-section. This is directly linked to asset pricing tests from Lustig et al. (2011), which have shown that currency baskets sorted on their interest rate differentials are all exposed to carry trade returns as a risk factor. Furthermore, this paper finds evidence that a decreased level of funding liquidity potentially leads to carry trade unwindings, controlling for equity and FX implied variance and skewness effects, which supports the theoretical model of liquidity spirals developed by Brunnermeier and Pedersen (2009).

Salvaging the C-CAPM: Currency Carry Trade Risk Premia and Conditioning Information

We use a standard consumption-based asset pricing model incorporating conditioning information to explain the risk-return pro…le of currency carry trade portfolios. We use a scaled stochastic discount factor instead of scaled or managed portfolio returns as in previous work. Our conditioning variable is a forward-looking measure of net foreign assets. It arises from an intertemporal budget constraint and has predictive power for exchange rates. We …nd that our conditional consumption-CAPM is able to price a large part of the variation in cross-section of carry trade portfolios using cross-sectional as well as time series regression-based tests. Taken together, our results imply that the consumption-based models do still have a role to play in explaining excess returns on carry trade strategies. JEL classi…cation: G0, G10, G12

Option-Implied Volatility Spillovers between Risk Factors in FX Markets and States of the Global Economy

This study employs option price data to back out the implied portfolio volatilities of the dollar and carry trade risk factors of the G-10 currencies. To investigate expected volatility spillover effects between risk factors in FX markets, we extend Grobys (2015) and Diebold and Yilmaz (2009) by constructing expected volatility spillover indices based upon the forecast-error variance decomposition of Vector-Autoregression models employing option-implied portfolio volatilities. Surprisingly, the dollar and carry trade risk factors that are orthogonal in the first moment exhibit strong stochastic interrelations in the second expected moment. Our findings indicate that expected high spillover regimes are associated with periods of economic stress.

The Term Structure of Exchange Rate Predictability: Commonality, Scapegoat, and Disageement

In this paper we study the exchange rate predictability across a range of investment horizons by return decomposition into forward premium component and carry trade risk premium component, for which we propose a term structure model to capture exchange rate dynamics with a broad set of predictors meanwhile handle both parameter and model uncertainties. We demonstrate the time-varying term-structural and model disagreement effects of exchange rate determinants as well as the projections of predictive information over the term structure. We also utilize the time-variation in the probability weighting from dynamic model averaging to identify the scapegoat drivers of customer order flows, which are also informative about the term structure of carry trade risk premia. Our findings reveal that heterogeneous agents learn to forecast exchange rates and switch trading rules over time, resulting in the dynamic country-specific and global exposures of exchange rates to short-run non-fundamental risk and long-run business cycle risk. Hedging pressure and liquidity are identified to contain predictive information that is common to a range of forecasting horizons. Policy-related predictors are important for short-run forecasts up to 3 months while crash risk indicators matter for long-run forecasts from 9 months to 12 months. We further comprehensively evaluate both statistical and economic significance of the model allowing for a full spectrum of currency investment management, and find that the model generates substantial performance fees of 6.5% per annum.

The Term Structure of Currency Carry Trade Risk Premia

Fixing the investment horizon, the returns to currency carry trades decrease as the maturity of the foreign bonds increases. Across developed countries, the local currency term premia, which increase with the maturity of the bonds, offset the currency risk premia. Similarly, in the time-series, the predictability of foreign bond returns in dollars declines with the bonds’ maturities. Leading no-arbitrage models in international finance do not match the downward term structure of currency carry trade risk premia. We derive a simple preference-free condition that no-arbitrage models need to reproduce in the absence of carry trade risk premia on long-term bonds. (JEL E43, G12, G15)

The Term Structure of Currency Carry Trade Risk Premia

We derive a novel test for nominal exchange rate stationarity that exploits the forward-looking information in long maturity bond prices. When nominal exchange rates are stationary, no arbitrage implies that the return on the foreign long bond expressed in dollars is identical to the return on the U.S. bond. In the data, we do not find significant differences in long-term government bond risk premia in dollars across G10 countries, contrary to the large differences in risk premia at short maturities documented in the FX carry trade literature. Moreover, in most of the cases examined, we cannot reject that realized foreign and domestic long-term bond returns in dollars are the same, as if nominal exchange rates were stationary in levels, contrary to the academic consensus.

The Math of Private Equity: 2/20, 3-on-5, and 1-in-8

Given the standard 10-year cycle of private equity (PE) funds, 2 percent year-on-year management fee on committed funds, and 20 percent carry fee charged by funds’ managers or general partners (GPs), a 3 times cash-on-cash return at disinvestment in 5 years is required to achieve median 15 percent return (IRR) for funds’ shareholders or limited partners (LPs). The implied 25 percent discount rate at which portfolio companies’ cash flows are valued is justified as exposure to non-diversifiable risk of failure. E.g., a 9 percent discount rate of a comparable company with a probability of failure of 1 in 8 yields a compound rate of 25 percent. Implications in turmoil times: (1) the 2/20 fee structure subject to cut down and evolution to dynamic schemes (e.g., on deployed funds); (2) EBITDA growth as the main source of PE return due to steady multiples and avoidance of over-leverage; (3) reduction of returns’ volatility by screening markets and sectors, and avoidance of carry trade risk. Conjectures: (a) sovereign funds weight increase as LPs, (b) market and sector specialization across funds, and (c) PE pitch switch from financial to managerial value added.

Commodity Trade and the Carry Trade: A Tale of Two Countries

Persistent differences in interest rates across countries account for much of the profitability of currency carry trade strategies. The high interest rate investment currencies tend to be currencies, while low interest rate funding currencies tend to belong to countries that export finished goods and import most of their commodities. We develop a general equilibrium model of international trade and currency pricing in which countries have an advantage in producing either basic input goods or final consumable goods. The model predicts that commodity-producing countries are insulated from global productivity shocks through a combination of trade frictions and domestic production, while the final good producers that drive the global business cycle also absorb the shocks. As a result, the commodity country currency is risky as it tends to depreciate in bad times, yet has higher interest rates on average due to lower precautionary demand, compared to the final good producer. The carry trade risk premium increases in the degree of specialization, and the real exchange rate tracks relative technological productivity of the two countries. The model's predictions are strongly supported in the data.

The Carry Trade Risk Factor on U.S. Stock Returns

Este articulo desarrolla un modelo de valoracion de activos en tiempo continuo para la economia global. En el articulo demuestro que un mercado financiero integrado, los retornos de los activos domesticos tienen un componente que compensa a los inversionistas por la exposicion a riesgo extranjero y demuestro que, este riesgo extranjero puede ser capturado por el retorno del carry trade. Usando un modelo de valoracion de activos multi-factorial pruebo por la presencia del riesgo global como un componente que afecta el retorno de las acciones norte americanas. El modelo se estima adicionando el retorno del carry trade a los tres factores de Fama y French y se presenta evidencia empirica a favor del carry trade como un factor adicional que explica el retorno de las acciones norte americanas.

Salvaging the C-Capm: Currency Carry Trade Risk Premia and Conditioning Information

We use a standard consumption-based asset pricing model incorporating conditioning information to explain the risk-return profile of currency carry trade portfolios. In contrast to previous work, we use a scaled stochastic discount factor instead of scaled or managed portfolio returns. Our conditioning variable is a forward-looking measure of the net foreign assets, arising from an intertemporal budget constraint, that allows for valuation changes in foreign assets and liabilities and has strong predictive power for multilateral exchange rates. We find that our conditional consumption CAPM that allow for time variation in consumption betas can price a large part of the variation in cross-section of carry trade portfolios. Taken together our results suggest that the consumption-based models do still have a role to play in explaining excess returns on carry trade strategies.