Carry Trade Research Articles

The Profitability of Using Pegged Currencies in Carry Trade: A Case of Saudi Riyal

This paper examines the profitability of using pegged currencies in carry trade. Conducting this exercise on Saudi riyal against six floating currencies has proven to be very rewarding especially when enhanced with forecasting methods. Carry trade is a very popular currency speculation strategy among traders, where they borrow low-interest currencies and invest in high-interest currencies. It is a strategy that takes advantage of interest rate differentials between two currencies. Such strategy should not work under uncovered interest parity (UIP), since according to UIP high interest rate currencies should depreciate against low interest rate currencies by the interest rate differential itself. But studies have shown that UIP does not stand and carry traders are profiting from it. As a result of its failure, carry traders are making returns matching the returns of the S&P 500 and outperforming it in terms of the Sharpe ratio.

Forecasting Covariance for Optimal Carry Trade Portfolio Allocations

Forecasting Covariance for Optimal Carry Trade Portfolio Allocations

Forecasting-Based Carry Trade Using Pegged Currency: A Case of Omani Rial

This paper examines the profitability of using an emerging country, currency that is pegged to the U.S. dollar in carry trade against floating currencies. It also examines the effect of embedding forecasting techniques in its profitability and risk-adjusted returns. While carry trade is performed largely with currencies that adapt a floating exchange rate system, conducting such a strategy using pegged currency has proven to be very rewarding, especially when the strategy is enhanced with forecasting methods. Carry trade is a speculative strategy where carry traders take advantage of interest rate differential between two currencies. It is conducted by borrowing a low interest rate currency and investing in a high interest rate currency. According to uncovered interest parity (UIP), carry trade should not yield any profit. If investors are both rational and risk-neutral, then exchange rate changes will eliminate any gains arising from the differential in interest rate. But literature has shown that UIP does not hold. This failure has led to unprecedented returns for that strategy matching the returns of the S&P 500 and outperforming it in terms of Sharpe ratio.

Currency Momentum, Carry Trade, and Market Illiquidity

This study empirically examines the effect of equity market illiquidity on the excess returns of currency momentum and carry trade strategies. Results show that equity market illiquidity explains the evolution of currency momentum strategy payoffs, but not carry trade. Returns on currency momentum are low following months of high equity market illiquidity. However, in the recent decade, illiquidity positively predicts the associated payoffs. The findings withstand various robustness checks and are economically significant, approximating in value to one-third of average monthly profits.

Carry Trades and Monetary Conditions

Carry Trades and Monetary Conditions

Carry Trades and Monetary Conditions

This paper investigates the relation between monetary conditions and the excess returns arising from an investment strategy that con- sists of borrowing low-interest rate currencies and investing in currencies with high interest rates, so-called trade. The results indicate that carry trade average excess return, Sharpe ratio and 5% quantile differ substantially across expansive and restrictive conventional mone- tary policy before the onset of the recent financial crisis. By contrast, the considered parameters are not affected by unconventional monetary policy during the financial crisis. JEL Classification: F31, G15, E52

Understanding the Interplay between Covariance Forecasting Factor Models and Risk Based Portfolio Allocations in Currency Carry Trades

Understanding the Interplay between Covariance Forecasting Factor Models and Risk Based Portfolio Allocations in Currency Carry Trades

Beyond the Carry Trade: Optimal Currency Portfolios

AbstractWe test the relevance of technical and fundamental variables in forming currency portfolios. Carry, momentum, and value reversal all contribute to portfolio performance, whereas the real exchange rate and the current account do not. The resulting optimal portfolio produces out-of-sample returns that are not explained by risk and are valuable to diversified investors holding stocks and bonds. Exposure to currencies increases the Sharpe ratio of diversified portfolios by 0.5 on average, while reducing crash risk. We argue that besides risk, currency returns reflect the scarcity of speculative capital.

Emerging Market Carry Trades and Financial Crises

Abstract This chapter identifies three crisis warning indicators driven from trading in emerging markets’ carry trades, and empirically examines whether these indicators could predict two major financial crises that hit the global financial markets in the last decades — The 1997–1998 Asian crisis and the 2007–2008 global crisis. The probit regression is used to examine the power of the three indicators in forecasting financial crises, using data from eight Asian emerging countries which serve as proxies for emerging markets, independent of the origination of the crisis. I use both fixed effect and random effect estimation to measure crisis impacts. The empirical results show that financial crises could have been predicted. Probit estimation show that carry trade returns can predict a financial crisis, and the estimation results are robust to both panel level and country-level analysis. These three indicators are by no means an exhaustive list of all possible predictors of financial crisis. The literature suggests other fundamental indicators of financial crises such as the current account deficit and foreign debt. However, this chapter cannot fully consider these indicators for lack of data at this point in time. Although financial crisis may be better predicted by the well-known fundamental indicators, the contribution of this chapter is simply that carry trade-related indicators can help in predicting crises.

Diversification Effect of Naave and Optimized Carry Trades

This paper investigates the diversification effect of optimized and naive carry trades. Naive carry trades lend (borrow) high (low)-yield currencies to capture the interest rate differential. In contrast, optimized carry trades select funding and investment currencies by an optimal trade-off between low FX volatility and implied interest rate differential, as the FX spot rate can ruin the carry trade return. The results show, that carry trades have a statistical and economical benefit for an institutional investor. Optimized carry trades have the largest and a positive diversification effect on the investor’s portfolio. In particular, optimized carry trades are able to enhance the risk-return profile over the whole observation period and during the financial crisis. Carry trades are implemented by alternative weighting schemes within a trading environment, such that the impact of different margins is discussed. The paper concludes, that investors can boost their portfolio performance, if optimized carry trades are included.

Currency Carry Trade and Bank's Foreign Exchange Risk Management

The role of the market makers is crucial in determining the foreign exchange risk premium in currency carry trade. A typical market maker of foreign exchange is a highly leveraged commercial bank or investment bank. I derive a model of foreign exchange risk premium from the perspective of a market maker, in which the required foreign exchange risk premium is proportional to the volatility of foreign exchange rate, the net foreign exchange exposure, and the financial leverage. The financial leverage amplifies small changes in net foreign exposure and volatility into large changes in the risk premium. This amplifier effect offers an explanation to the foreign exchange risk premium puzzle. I use this model to examine the negative interest rate differential between Japan and the U.S. in the 1990s.

The Carry Trade and Uncovered Interest Parity When Markets Are Incomplete

Many of the leading models of the carry trade imply that, contrary to the empirical evidence, a country's currency depreciates in times of high consumption and output growth, a manifestation of the Backus and Smith (1993) puzzle. We propose a modification of these models to account for financial market incompleteness and show that such a modification can induce positive correlation between currency appreciation and consumption or output growth while, at the same time, helping resolve the Backus and Smith (1993) and Brandt, Cochrane and SantaClara (2006) puzzles. Furthermore, in many of the existing models, the assumed fundamental cross-country differences (output volatility, growth, and risk attitude) responsible for interest rate differentials also appear at odds with the data. We document that default risk and financial openness are strongly related to interest rate differentials and carry trade profits in the data. The incomplete markets model we propose is consistent with these novel empirical facts.

Trade Network Centrality and the Currency Carry Trade

I uncover an economic source of exposure to global risk that drives international asset prices. Countries which are more central in the global trade network have lower interest rates and currency risk premia. As a result, an investment strategy that is long in currencies of peripheral countries and short in currencies of central countries explains unconditional carry trade returns. To explain these findings, I present a general equilibrium model where central countries’ consumption growth is more exposed to global consumption growth shocks. This causes the currencies of central countries to appreciate in bad times, resulting in lower interest rates and currency risk premia. In the data, central countries’ consumption growth is more correlated with world consumption growth than peripheral countries’, further validating the proposed mechanism.

Australian Dollar Carry Trades: Time Varying Probabilities and Their Determinants

This paper investigates the nature and the determinants of the Australian Dollar (AUD) carry trades using a Markov regime shifting model over the period 2 Jan 1999 to 31 Dec 2012. We find that the AUD could have been used, except for a number of short periods notably surrounding the outbreak of the GFC, as an investment currency in a carry trade regime. For daily horizon, prior to September 2008, carry trade probabilities are significantly lower in response to higher realized volatility of the USD/AUD, number of trades, the announcements of unexpected inflation and unemployment in Australia. They are significantly higher when order flows are positive (more buyer than seller initialed trades of AUD) and when RBA policy interest rate unexpectedly increase. At weekly horizon, realized skewness and net long futures position in the AUD contributed to the carry trade probabilities. On the other hand, post-September 2008 period shows a breakdown in the relationship between the carry trade probabilities and their determinants.

Carry Trades and Tail Risk of Exchange Rates

Historically, Carry trades have been a success story for most investor and a major source of funds for emerging economies maintaining higher interest rates. Therefore it’s a timely topic to investigate the risk embedded in such transactions and to what extent the carry trade returns explain the tail risk. Initially, this research estimates the tail index of all the currencies and formulates a unique inverse function for all the currencies in relation to Power laws, with the idea of estimating the respective Value-at-Risk. This research considers twenty five currencies and replicates them in to five portfolios based on the annualised daily return of a weekly forward contract. Trade was executed assuming a U.S. investor, who goes long in a high return portfolio and short in a low return portfolio. Further, this research examines the impact of carry trade returns on the overall tail risk within the context of foreign exchange and interest rate gain in long and short positions of the trade. The results indicate that tail risk cannot be explained effectively by its returns because of its exponential nature. However, I find that tail risk is mostly influenced by the long position of the carry trade. Furthermore, the return of the foreign exchange component appears to have a better explanation on the tail risk compared to the interest rate return. The Value-at-Risk analysis also suggests that the tail risk of overall strategy is influenced by the tail risk of foreign exchange component embedded in the long position of the trade.

Cross-Asset Return Predictability: Carry Trades, Stocks and Commodities

Cross-Asset Return Predictability: Carry Trades, Stocks and Commodities

A Thermometer for Financial Instability in the Euro Area Economy and the Role of Carry Trade

This study suggests a simple financial instability indicator for the euro area economy. It works as a discrete thermometer with three possible outcomes depending on the severity of the crisis. This indicator is based on the specific shape of the credit term structure for the two main peripheral countries in the area. The paper discusses how some key features of term structure are linked to government debt carry trade. In order to assess the performance of the proposed market-based indicator, the paper shows how the identified episodes of financial turmoil are related with the timing and the intensity of unconventional measures in the euro area.

Carry Trades, Order Flow and the Forward Bias Puzzle

We investigate the relation between foreign exchange (FX) order flow and the forward bias. We outline a decomposition of the forward bias according to which a negative correlation between interest rate differentials and order flow creates a time-varying risk premium consistent with that bias. Using ten years of data on FX order flow we find that more than half of the forward bias is accounted for by order flow --- with the rest being explained by expectational errors. We also find that carry trading increases currency-crash risk in that order flow generates negative skewness in FX returns.

Carry Trade e Risco Cambial: um Conto de Dois Fatores

Retornos da estrategia de carry trade tem sido explicados usando-se funcoes de utilidade inseparaveis no tempo que permitem premios de risco volateis. Tipicamente tais funcoes mimetizam as preferencias de economia fechada que dependem de bens duraveis e nao duraveis. Este trabalho retorna a uma classificacao mais tradicional, em macroeconomia internacional, de consumo entre bens domesticos e importados. O modelo e aplicado para paises que representam 98,2% do volume mundial do comercio bilateral de câmbio. Reporta-se uma melhora acentuada na significância dos betas de consumo.

Global Equity Correlation in Carry and Momentum Trades

We provide a risk-based explanation for the excess returns of two widely-known currency speculation strategies: carry and momentum trades. We construct a global equity correlation factor and show that it explains the variation in average excess returns of both these strategies. The global correlation factor has a robust negative price of beta risk in the FX market. We also present a multi-currency model which illustrates why heterogeneous exposures to our correlation factor explain the excess returns of both portfolios.