Carry Trade Strategies Research Articles

Currency excess returns and global downside market risk

We assess cross-sectional differences in 23 bilateral currency excess returns in an empirical model that distinguishes between US-specific and global risks, conditional on US bull (upside) or bear (downside) markets. Using the US dollar as numeraire currency, our results suggest that global downside risk is compensated in conditional and unconditional, bilateral currency excess returns. This finding is mostly driven by the emerging markets' currencies in our sample. We also find that the link between the global downside risk and risks associated with a typical carry trade strategy is much weaker for emerging markets' currencies than for developed markets' currencies.

What Explains the Initial Return of Initial Public Offerings after the 1997 Asian Financial Crisis? Evidence from Thailand

Do financial development, domestic interest rates, and interest-rate differentials simultaneously affect the underpricing of initial public offerings (IPOs) in emerging market countries? Using a sample of 187 IPOs in Thailand between 2000 and 2012, I show that financial development, stock market conditions, bond market development, and interest-rate differentials affect the initial return, and that several of these effects appear to be contingent on (1) whether the IPOs are hot or cold and (2) whether the interest-rate differential is positive or not. During periods of positive interest-rate differentials, the effect of the interest-rate differential on the initial return is positive and economically significant. Overall, my findings suggest that investors might undertake carry-trade strategies in the IPO market. In addition, the initial return of the IPOs in my sample appears to be lower than the initial returns reported by previous studies using the pre-1997 financial crisis period sample.

What explains the initial return of initial public offerings after the 1997 Asian financial crisis? Evidence from Thailand

Do financial development, domestic interest rates, and interest-rate differentials simultaneously affect the underpricing of initial public offerings (IPOs) in emerging market countries? Using a sample of 187 IPOs in Thailand between 2000 and 2012, I show that financial development, stock market conditions, bond market development, and interest-rate differentials affect the initial return, and that several of these effects appear to be contingent on (1) whether the IPOs are hot or cold and (2) whether the interest-rate differential is positive or not. During periods of positive interest-rate differentials, the effect of the interest-rate differential on the initial return is positive and economically significant. Overall, my findings suggest that investors might undertake carry-trade strategies in the IPO market. In addition, the initial return of the IPOs in my sample appears to be lower than the initial returns reported by previous studies using the pre-1997 financial crisis period sample.

Optimal currency carry trade strategies

This paper studies the optimal asset allocation problem of an investor with a portfolio given by the U.S. risk-free asset and a carry trade benchmark comprising the currencies of the G10 countries. Our optimal strategy is able to adapt to macroeconomic conditions and avoid the so-called crash risk inherent in standard carry trade strategies by constructing a vector of dynamic weights that depends on a set of state variables. We find that the U.S. Ted spread, the U.S. average forward discount, the CRB Industrial return, and a global monetary policy indicator are the key drivers of optimal currency carry trade strategies.

Carry trade: benefits and risks

Empirical studies have shown that carry trade plays an increasingly important role in driving exchange rate movements. In this paper, we analyse the two prominent types of carry trade strategy namely covered interest parity (CIP) and uncovered interest parity (UIP) by examining the benefits and exchange rate risks in an unexpected high volatile environment in emerging markets. The influence of sovereign and liquidity risks on carry trade is also investigated. Since carry trade can have an enormous impact on macro-economic factors, understanding basic characteristics of carry trade will be useful for both researchers and policy makers in countries susceptible to carry trade speculations.

Countercyclical currency risk premia

We describe a novel currency investment strategy, the ‘dollar carry trade,’ which delivers large excess returns, uncorrelated with the returns on well-known carry trade strategies. Using a no-arbitrage model of exchange rates we show that these excess returns compensate U.S. investors for taking on aggregate risk by shorting the dollar in bad times, when the U.S. price of risk is high. The countercyclical variation in risk premia leads to strong return predictability: the average forward discount and U.S. industrial production growth rates forecast up to 25% of the dollar return variation at the one-year horizon. The estimated model implies that the variation in the exposure of U.S. investors to worldwide risk is the key driver of predictability.

Currency Carry Trades, Position-Unwinding Risk, and Sovereign Credit Premia

This is the first study that employs option pricing model to measure the position-unwinding risk of currency carry trade portfolios, which well covers the moment information. We show that high interest-rate currencies are exposed to higher position-unwinding risk than low interest-rate currencies. We also investigate the sovereign CDS spreads as the proxy for countries' credit conditions and find that high interest-rate currencies load up positively on sovereign default risk while low interest-rate currencies provide a hedge against it. Sovereign credit premia as the dominant economic fundamental risk, together with position-unwinding likelihood indicator as the market risk (nonneutrality) sentiment, captures over 90% cross-sectional variations of carry trade excess returns. We identify sovereign credit risk as the impulsive country-specific risk that drives market volatility, and also its global contagion channels. Then We propose an alternative carry trade strategy immunized from crash risk, and a composite story of sovereign credit premia, global liquidity imbalances and liquidity reversal/spiral for explaining the forward premium puzzle.

The performance of NDF carry trades

This paper investigates the performance of carry trade strategies for currencies with non-deliverable forward (NDF) contracts. We find that carry trades for currencies with NDF contracts are associated with higher Sharpe ratios compared to carry trades for currencies with deliverable forward (DF) contracts. We also find that, during the recent financial crisis, DF carry trades incur heavy losses while NDF carry trades realize insignificant losses. DF carry trade payoffs are shaped by credit risk, global foreign exchange (FX) volatility and crash risk. In contrast, NDF carry trade payoffs are driven by global FX volatility and crash risk, liquidity risk, and currency convertibility risk measured by deviations from covered interest parity in offshore markets while global convertibility risk has a limited effect on carry trades.

The Performance of NDF Carry Trades

This paper investigates the performance of carry trade strategies for currencies with non-deliverable forward (NDF) contracts. We find that carry trades for currencies with NDF contracts are associated with higher Sharpe ratios compared to carry trades for currencies with deliverable forward (DF) contracts. We also find that, during the recent financial crisis, DF carry trades incur heavy losses while NDF carry trades realize insignificant losses. DF carry trade payoffs are shaped by credit risk, global foreign exchange (FX) volatility and crash risk. In contrast, NDF carry trade payoffs are driven by global FX volatility and crash risk, liquidity risk, and currency convertibility risk measured by deviations from covered interest parity in offshore markets while global convertibility risk has a limited effect on carry trades.

Carry Trade and Systemic Risk: Why are FX Options So Cheap?

In this paper we document first that, in contrast with their widely perceived excess returns, popular carry trade strategies yield low systemic-risk-adjusted returns. In particular, we show that carry trade returns are highly correlated with the return of a VIX rolldown strategy --i.e., the strategy of shorting VIX futures and rolling down its term structure-- and that the latter strategy performs at least as well as beta-adjusted carry trades, for individual currencies and diversified portfolios. In contrast, hedging the carry with exchange rate options produces large returns that are not a compensation for systemic risk. We show that this result stems from the fact that the corresponding portfolio of exchange rate options provides a cheap form of systemic insurance.

Market Microstructure and the Profitability of Currency Trading

Currency trading is a vast and highly profitable business. This review examines the profitability of two popular currency trading strategies in light of currency-market microstructure research. The carry-trade strategy involves borrowing a low-interest currency and investing the proceeds in a high-interest currency. Technical trading strategies are determined exclusively on the basis of past asset prices and trading volumes. Under the efficient markets hypothesis, neither of these approaches to speculative trading should produce excess returns. The review shows that the profitability of carry-trade investing and technical trading strategies can represent rational long-run equilibria given the structure of currency markets and the incentives and constraints faced by traders.

The "hot money" phenomenon in Brazil

Because of its high interest rates, Brazil attracts more and more speculative capital flows, called "hot money", under the form of foreign loans, direct or portfolio investments. Actually, the country is directly involved in a carry-trade strategy that tends to appreciate the real, what penalizes the Brazilian exportations of manufactured products. Moreover, capital inflows are extremely volatile, and their departure, causing a fall in loans granted to the Brazilian private banks, could provoke a dangerous burst of the speculative bubble they have contributed to form in the Brazilian real estate sector.

The Crash Risk Premia of Efficient Carry Trades

Carry trade strategies in which investors sell forward currencies that are at a forward premium and buy forward currencies that are at a forward discount are, on average, profitable. According to the uncovered interest rate parity they should not. A risk premia story might justify the high returns to the carry trades. In this paper we study the relationship between the cross section of excess returns of portfolios invested in carry trade positions and a renewed set of candidate risk factors. Asset pricing theory applies to the currency market: those currencies that have larger loading on risk, especially crash risk, offer a larger mean return in compensation. Especially, we show that crash risk as measured by quantile based statistics such as VaR or CVaR prices better the return to the carry trades than moments based factors such as standard deviation or skewness. This result holds at the portfolio level and at the single currency level. As a result, we show that carry trade strategies that take account of the dispersion of interest rates dominate strategies in which bets are normalized.

The “forward premium puzzle” and the sovereign default risk

Carry-trade strategies which consist of buying forward high-yield currencies tend to yield positive excess returns when global financial markets are booming, whereas they generate losses during crises. Firstly, we show that the sovereign default risk, which is taken on by investing in high-yield currencies, may increase the magnitude of the gains during the boom periods and the losses during crises. We empirically test for this hypothesis on a sample of 18 emerging currencies over the period from June 2005 to September 2010, the default risk being proxied by the sovereign credit default swap spread. Relying on smooth transition regression (STR) models, we show that default risk contributes to the carry-trade gains during booms, and worsens the losses during busts. Secondly, we turn to the “Fama regression” linking the exchange-rate depreciation to the interest-rate differential. We propose a nonlinear estimation of this equation, explaining the puzzling evolution of its coefficient by the change in the market volatility along the financial cycle. Then, we introduce the default risk into this equation and show that the “forward bias”, usually evidenced by a coefficient smaller than unity in this regression, is somewhat alleviated, as the default risk is significant to explain the exchange-rate change.

Risk-premia, carry-trade dynamics, and economic value of currency speculation

In this paper, we derive the dynamics and assess the economic value of currency speculation by formalizing the concept of a trader inaction range. We show that exchange rate returns comprise a time-varying risk-premium and that uncovered interest parity (UIP) holds in a speculative sense. The often-cited ‘forward bias puzzle’ originates from the omission of the risk-premium in standard UIP tests. Consistent with its popularity among market professionals, the carry-trade strategy can be rationalized as it systematically collects risk-premia, however, the economic value generated by bilateral carry-trades is limited.

Modeling Exchange Rate Volatility Using Realized GARCH

We apply the Realized GARCH model in the foreign exchange market. With daily data, we find that the Realized GARCH model has better in-sample and out-of-sample performances than a standard GARCH or IGARCH model. On the other hand, GARCH gives better forecasts of conditional variances if weekly data are used. We then propose a dynamic carry trade strategy that uses variance forecasts to determine the optimal portfolio weights. Using variances predicted by a Realized GARCH model, the strategy generates annual Sharpe ratios ranging from 0:6 to 0:9 consistently, which outperforms industrial benchmark indices.

Lessons from the Evolution of Foreign Exchange Trading Strategies

The adaptive markets hypothesis posits that trading strategies evolve as traders adapt their behavior to changing circumstances. This paper studies the evolution of trading strategies for a hypothetical trader who chooses portfolios from foreign exchange (forex) technical rules in major and emerging markets, the carry trade, and U.S. equities. The results show that forex trading alone dramatically outperforms the S&P 500 but there is little gain to coordinating forex and equity strategies, which explains why practitioners consider these tools separately. In addition, a backtesting procedure to choose optimal portfolios does not select carry trade strategies until well into the 1990s, which helps to explain the relatively recent surge in interest in this strategy. Forex trading returns dip significantly in the 1990s but recover by the end of the decade and have greatly outperformed an equity position since 1998. Overall, trading rule returns still exist in forex markets—with substantial stability in the types of rules—though they have migrated to emerging markets to a considerable degree.

Countercyclical Currency Risk Premia

We describe a novel currency investment strategy, the `dollar carry trade,' which delivers large excess returns, uncorrelated with the returns on well-known carry trade strategies. Using a no-arbitrage model of exchange rates we show that these excess returns compensate U.S. investors for taking on aggregate risk by shorting the dollar in bad times, when the price of risk is high. The counter-cyclical variation in risk premia leads to strong return predictability: the average forward discount and U.S. industrial production growth rates forecast up to 25% of the dollar return variation at the one-year horizon.

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.

Countercyclical Currency Risk Premia

We describe a novel currency investment strategy, the ‘dollar carry trade,’ which delivers large excess returns, uncorrelated with the returns on well-known carry trade strategies. Using a no-arbitrage model of exchange rates we show that these excess returns compensate U.S. investors for taking on aggregate risk by shorting the dollar in bad times, when the U.S. price of risk is high. The countercyclical variation in risk premia leads to strong return predictability: the average forward discount and U.S. industrial production growth rates forecast up to 25% of the dollar return variation at the one-year horizon. The estimated model implies that the variation in the exposure of U.S. investors to worldwide risk is the key driver of predictability.