Currency Carry Trade Research Articles

The Impact of Currency Carry Trade Activity on the Transmission of Monetary Policy

The Impact of Currency Carry Trade Activity on the Transmission of Monetary Policy

Currency Carry Trade by Trucks: The Curious Case of China’s Massive Imports from Itself

AbstractWith capital controls, the standard financial market transactions needed for currency carry trade are hard to implement. Using detailed trade data reported by both the mainland Chinese and Hong Kong’s governments, we present evidence that indirect currency carry trade likely takes place via round-trip reimports. We also show that greater state control in terms of more state-owned firms does not reduce such “carry trade by trucks.”

Currency Carry Trade by Trucks: The Curious Case of China's Massive Imports from Itself

Currency Carry Trade by Trucks: The Curious Case of China's Massive Imports from Itself

Currency Carry Trades and Global Funding Risk

We measure funding constraints in international currency markets by deviations in the covered interest rate parity. Our measure of funding risk is the standard deviation of the magnitude of the funding constraints. This funding risk measure appears to be driven by conditions in the financial sector in the low interest rate, so called carry trade short countries, oil price volatility, as well as by the actions of the main central banks. Although funding risk has been present throughout our sample, it becomes only relevant in currency carry trading after 2008, suggesting that investors’ funding constraints start binding at that time. We document evidence that since 2008 funding risk has affected the magnitude of currency carry trading activity, carry trade returns, correlation between carry long and short currencies, relative equity returns in carry trade long vs. short countries, and the economies of carry trade long countries measured through changes in industrial production. We develop a theory of currency markets under funding constraints that has several testable implications. For instance, as funding constraints start to bind, our theory predicts that both the investment and funding currencies drop relative to a safe asset. This result is observable also in our empirical analysis, when we proxy for the safe asset with gold. In line with theory, funding risk forecasts currency crashes in the carry trade long and short countries.

Sovereign CDS and Currency Carry Trades: Two Tales in Developed and Emerging Economies

Sovereign CDS and Currency Carry Trades: Two Tales in Developed and Emerging Economies

Currency Carry Trades and the Conditional Factor Model

This study employs a conditional factor model in order to investigate the time-varying profitability of currency carry trades. To that end, I estimate conditional alphas and betas on the popular dollar and carry factors through the use of a nonparametric approach. The empirical results illustrate that the alphas and betas vary over time. Furthermore, I find that the alpha of a high interest rate currency portfolio increases in a trough in a business cycle and in a state of high market uncertainty. However, the beta on the dollar factor decreases in these market conditions, suggesting that investors reduce the foreign currency risk exposure.

Crash-o-phobia in Currency Carry Trade Returns

Currency carry trade returns are on average large and non-normally distributed. While the literature has found different explanations for the existence of carry trade returns, the higher order moments of their return distribution still pose a puzzle. We propose a new model to explain these non-normal properties of currency carry trade returns, by assuming that agents are loss averse and overweight states with low probabilities. This combination of loss aversion and probability weighting is called crash-o-phobia. Using non-linear least squares and risk-neutral state prices implied by currency options, we estimate this crash-o-phobia model to price developed and emerging market currencies. The parameter estimates reveal crash-o-phobic beliefs and preferences with significant differences across currencies. Compared to a model with rational beliefs and CRRA utility, our crash-o-phobia model performs significantly better at explaining the whole distribution of currency carry trade returns.

Conditioning carry trades: Less risk, more return

Prior studies show that extreme interest rate differentials (IRDs) and high foreign exchange rate (FX) volatility have substantial explanatory power for the validity of UIP. We show that these contemporaneous drivers also have predictive power by implementing a conditional currency carry trade (CT) strategy that excludes regimes for which UIP is likely to hold. Conditioning high FX volatility only, or on both FX volatility and extreme IRDs outperforms the base-case unconditional CT strategy in virtually any of the settings analyzed. Conditioning on very large IRDs only shows mixed findings. Our strategy works best for smaller CT portfolios.

The Currency Carry Trade

The Currency Carry Trade

Using Option-Implied Information to Improve Currency Carry Trade Profits

This study investigates an efficient parametric portfolio policy model to improve the return distribution of the well-known currency carry trade investment strategy. This carry trade strategy invests into high-yielding currencies that are subsequently funded by low-yielding currencies. Following this investment procedure has led to significantly excess returns for the investors, at least over the past four decades. However, these returns were subject to a high crash risk, which hit its peak during the US subprime crisis in 2008/2009 with portfolio losses of up to one third of the investment value. The constructed model overcomes these bad portfolio properties through computing the optimal carry trade portfolio weight for any monthly revolving investment period. This is done by modeling the optimal weight as a function of the carry trade’s risk characteristics. Especially, when using global FX option-implied variance risk, as well as global consumer price inflation and commodity prices as background risk factors, the model delivers extremely-efficient out-of-sample results with annualized mean returns of up to 8.4% over an eight-year period, accompanied with a low standard deviation, positively skewed returns and leading to Sharpe ratios around unity, including transaction costs. These promising statistics are largely maintained when allowing for higher leveraged portfolios.

The Currency Carry Trade: Selection Skill or Behavioral Bias

<p>Many attempts have been undertaken to solve the forward premium puzzle with little to no success. The global currency market is considered the most information efficient and transparent of all financial markets since it demonstrates a balance between over and under-reaction to information with remarkable consistency. The Efficient Market Hypothesis espouses investors cannot systematically outperform a benchmark since all investors have access to the same information. Therefore, the expected long-term rate of return for currencies is essentially zero. The Arbitrage Pricing Theory asserts investment returns are random. As such, traders cannot avail themselves of mispriced currencies. The assertion of Uncovered Interest Rate Parity is that bi-national interest rate variance is equal to the expected differential in exchange rates. This paper asks the following questions: does alpha persistence exist in currency carry trade funds or are its excess returns merely a collection of behavioral biases?</p>

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

The Effect of Political Risk on Currency Carry Trades

This paper explores the risk profile of individual currency carry trades. Findings indicate that carry trade profitability depends on a country’s political risk, supporting the risk-based view on forward bias. Political risk effect originates as a component of government actions and is more pronounced in emerging economies and in countries with high interest differentials.

Currency Carry Trades: The Role of Macroeconomic News and Futures Market Speculation

This paper investigates carry trade opportunities in major currencies against the US dollar over the period January 2, 1999 to December 31, 2012. There is evidence of significant Australian dollar (AUD), Euro, and Japanese yen (JPY) carry trades during noncrisis periods. The AUD (JPY) was an investment (a funding) currency, and the Euro was both. However, cross currency carry trades were not present. For the AUD and JPY, carry trades were more likely with low volatility and volume. Macroeconomic news that appreciate (depreciate) the AUD (the JPY) also stimulated the AUD (the JPY) carry trades. However, there is no evidence of meaningful and consistent impact of macroeconomic news on the EUR carry trades. For weekly horizon investigations, net long futures positions in the AUD promoted carry trades in the AUD and JPY. However, net long positions in the JPY only managed to reduce JPY carry trade probability. © 2016 Wiley Periodicals, Inc. Jrl Fut Mark 36:1076–1107, 2016

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

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.

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.

Currency Carry Trade Portfolios and Its Sensitivity to Interest Rates

This paper provides an empirical investigation of naive and optimized carry trades for G10 and emerging market currencies. Additionally, the role of the interest rate delta between funding and investment currency is discussed.Naive carry trades select funding and investment currency by the level of the implied interest rate. Optimized carry trades consider the FX dynamic as a second selection criteria aiming to enhance the risk-return profile. Optimized carry trades are less correlated to the U.S. equity market and are more profitable during the recent financial crises, than naive carry trades. The paper concludes, that optimized carry trades are a useful strategy under financial stress.The impact of the interest rate delta is discussed by sensitivities. Contrarily to naive carry trades, sensitivities of optimized carry trades follow a determined shape, such that the impact of each interest rate on the risk-return profile is exante known. This helps to understand, which interest rate is mainly siphoned off by the carry trade, such that the unknown, future FX spot rate has an essential influence on the carry trade.

Time Varying Probabilities of Currency Carry Trades and Their Determinants: Markov Regime Shifting Models for the AUD and Yen

We investigate carry trade opportunities in major currencies against the US Dollar over the period 2 Jan 1999 to 31 Dec 2012. There is evidence of significant Australian Dollar (AUD), Euro and Japanese Yen (JPY) carry trades during non-crisis periods. The AUD (JPY) was an investment (a funding) currency, and the Euro was both. However, cross currency carry trades were not present. For the AUD and JPY, we find that carry trades were more likely with low volatility and volume. Macroeconomic news that appreciate (depreciate) the AUD (the JPY) also stimulated the AUD (the JPY) carry trades. However, there is no evidence of meaningful and consistent impact of macroeconomic news on the EUR carry trades. For weekly horizon investigations, we find that net long futures positions in the AUD promoted carry trades in the AUD and JPY. However, net long positions in the JPY only managed to reduce JPY carry trade probability.

Reinvestigating the Uncovered Interest Rate Parity Puzzle Via Analysis of Multivariate Tail Dependence in Currency Carry Trades

The currency carry trade is the investment strategy that involves selling low interest rate currencies in order to purchase higher interest rate currencies, thus profiting from the interest rate differentials. This is a well known financial puzzle to explain, since assuming foreign exchange risk is uninhibited and the markets have rational risk-neutral investors, then one would not expect profits from such strategies. That is uncovered interest rate parity (UIP), the parity condition in which exposure to foreign exchange risk, with unanticipated changes in exchange rates, should result in an outcome that changes in the exchange rate should offset the potential to profit from the interest rate differentials. Given foreign exchange market equilibrium, the interest rate parity condition implies that the expected return on domestic assets will equal the exchange rate-adjusted expected return on foreign currency assets. However, it has been shown empirically, that investors can actually earn profits by borrowing in a country with a lower interest rate, exchanging for foreign currency, and investing in a foreign country with a higher interest rate, whilst allowing for any losses (or gains) from exchanging back to their domestic currency at maturity. Therefore trading strategies that aim to exploit the interest rate differentials can be profitable on average. The intention of this paper is therefore to reinterpret the currency carry trade puzzle in light of heavy tailed marginal models coupled with multivariate tail dependence features. We analyse the returns of currency carry trade portfolios adjusting for tail dependence risk. To achieve this analysis of the multivariate extreme tail dependence we develop several parametric models and perform detailed model comparison. It is thus demonstrated that tail dependencies among specific sets of currencies provide other justifications to the carry trade excess return and also allow us to detect construction and unwinding periods of such carry portfolios.