High Interest Rate Currencies Research Articles

“Superstitious” Investors

Abstract We reconsider the excess volatility puzzle through the lens of a model in which agents believe they can predict dividend growth when in fact they cannot. Besides excess volatility in the time series, the model explains the value premium, and the explanatory power of the value factor. In support of the model, we show that analysts’ earnings forecasts align with market valuation and that analysts are far more optimistic about growth stocks than they are about value stocks. Using both survey and price data, we show that the same mechanism can explain the excess returns earned by investing in high-interest rate currencies. JEL G12, G15, G41

Carry trades and US monetary policy

AbstractI document that Federal Reserve expansionary monetary policy has a positive impact on the excess returns arising from currency carry trades. I show that expansive monetary surprises are associated with an increase in future real interest differentials between high interest rate currencies and the US dollar, which leads to higher capital flows toward those currencies and an increase in their returns. Since this increase is not fully compensated by a decrease in the returns from the short position in low interest rate currencies, unexpected monetary expansions in the US result in higher carry trade returns.

Puzzling exchange rate dynamics and delayed portfolio adjustment

The objective of this paper is to show that the proposal by Froot and Thaler (1990) of delayed portfolio adjustment can account for a broad set of puzzles about the relationship between interest rates and exchange rates. The puzzles include: i) the delayed overshooting puzzle; ii) the forward discount puzzle (or Fama puzzle); iii) the predictability reversal puzzle; iv) the Engel puzzle (high interest rate currencies are stronger than implied by UIP); v) the forward guidance exchange rate puzzle; vi) the absence of a forward discount puzzle with long-term bonds. These results are derived analytically in a simple two-country model with portfolio adjustment costs. Quantitatively, this approach can match all targeted moments related to these puzzles.

Common Idiosyncratic Volatility and Carry Trade Returns

I provide new evidence that incomplete consumption risk sharing across countries is an important determinant of carry trade returns. I show that there is a strong co-movement in idiosyncratic volatilities over time, and that shocks to the common idiosyncratic volatility (CIV) factor, defined as the equally weighted average of the idiosyncratic volatilities in the cross-section, are priced. I find that high-interest rate currencies deliver low returns when the CIV increases, which are bad times for investors. Low-interest rate currencies provide a hedge by yielding positive returns. CIV shocks remain an empirically powerful risk factor in explaining the cross-section of carry trade returns after controlling for global foreign exchange (FX) volatility risk. Furthermore, CIV risk is correlated with cross-country income risk faced by households. My findings are consistent with a heterogeneous-agent model with persistent, uninsurable idiosyncratic shocks in consumption growth. The calibrated model quantitatively accounts for the cross-sectional differences in average returns across CIV-beta sorted portfolios for plausible market prices of CIV risk.

Exploring Currency Risk Factors via Corridor Implied Volatility and Its Term Structures

This paper extends the application of corridor implied volatility by Andersen et al. (2015) to currency market, empirically measuring currency risks at multiple horizons, and finds its term structure contains useful information, both for profitable trading strategies and for common risk factors constructions on the basis of Lustig et al. (2011). I consistently find that for currencies paired by US dollars, the term structure of currency risk is flat at a low level prior to the 2008 crisis, upward-sloping after the crisis and peaks at a high level with a prominently negative slope during the crisis. This work is believed to be new in the currency research field. I then use this information to build trading strategies, earning a profit by longing currencies with the highest level or slope and shorting ones with the lowest level or slope. The profit by sorting slope is significantly high and robust to the 2008 crisis period, with a low correlation to the Carry Trade return, suggesting extra information in risk than the interest rate. Next, I extract global risk factors by level and slope to help understand the currency excess return, a long-lasting puzzle. The global risk factor by level substantially improves the cross-sectional explanatory power in currency excess returns compared to Lustig et al. (2011). Furthermore, I show that there is certain high risk corresponding to a high level and low slope, and high interest rate currency earns returns co-varying negatively to this risk, implying that it is a risky asset and thus requires a high risk premium, which explains the Carry Trade return well.

Long Run and Short Run Risk Premium in Currency Market

In this paper, I investigate risk premium of long run and short run volatility component of exchange rate returns in currency market. I find that high interest rate currencies of carry trade strategy load negatively on long run volatility innovation, while low interest rate currencies load positively. Risk price of long run volatility innovation is negative which implies that high carry trade returns are considered as compensation for time varying long run volatility risk. In contrast, risk price of short run volatility innovation is positive. Low interest currencies deliver low returns and high interest rate currencies yield high returns under times of high short run volatility. In terms of momentum strategy, risk price of short run volatility innovation is negative and statistically significant, while risk price of long run component is insignificant. Therefore, long run volatility does not provide any explanation for high returns of currency momentum strategy. High momentum returns, on the other hand are reward for investors to bear short run volatility risk.

Puzzling Exchange Rate Dynamics and Delayed Portfolio Adjustment

The objective of this paper is to show that the proposal by Froot and Thaler (1990) of delayed portfolio adjustment can account for a broad set of puzzles about the relationship between interest rates and exchange rates. The puzzles include: i) the delayed overshooting puzzle; ii) the forward discount puzzle (or Fama puzzle); iii) the predictability reversal puzzle; iv) the Engel puzzle (high interest rate currencies are stronger than implied by UIP); v) the forward guidance exchange rate puzzle; vi) the absence of a forward discount puzzle with long-term bonds. These results are derived analytically in a simple two-country model with portfolio adjustment costs. Quantitatively, this approach can match all targeted moments related to these puzzles.

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.

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.

Solvency risk premia and the carry trades

This paper shows that currency carry trades can be rationalized by the risk premia originating from the sovereign solvency risk. We find that solvency risk is a key determinant of risk premia in the cross section of carry trade returns, as its covariance with currency returns captures a substantial part of the cross-sectional variation of carry trade returns. Importantly, low interest rate currencies serve as insurance against solvency risk, while high interest rate currencies expose investors to more risk. The results are not attenuated by existing risks and pass a broad range of various robustness checks.

Uncovered Interest Rate Parity, Carry Trade, and Country Equity Return Differentials

This paper applies a mixed effect model to investigate the relationship between international equity returns and forward discount sorted currency returns from three base currencies (i. e., US dollar, euro, and pound sterling). Empirical results using the portfolio approach show that high-interest rate currencies co-move positively while low-interest rate currencies co-move negatively, suggesting that foreign equity excess returns can help to explain investment in currency markets, providing a partial resolution to the uncovered interest parity conundrum. Furthermore, we show that global equity market returns, volatility, and liquidity correlate well with currency returns.

Intertemporal Substitution, Precautionary Saving, and the Currency Premium

There are two seemingly contradictory empirical regularities in international finance: the high interest rate currency tends to have higher currency risk premia in short horizons but lower currency risk premia in long horizons. Engel (2016) shows that existing models cannot accommodate these two puzzles simultaneously and terms them a paradox. In this paper, we provide a rational resolution to Engel's paradox. Our deviation from existing models is the following two assumptions on consumption processes: (i) the expected future consumption variance have more than one decay modes and (ii) the mean consumption growth depends on the slowest decay mode. Market friction, recursive utility and bounded rationality are not assumed. Calibration exercises confirm key implications of our model.

Solvency Risk Premia and the Carry Trades

The paper shows that currency carry trades can be rationalized by the time-varying risk premia originating from the sovereign solvency risk. We find that solvency risk is a key determinant of risk premia in the cross section of carry trade returns, as its covariance with returns captures a substantial part of the cross-sectional vraiation of carry trade returns. Importantly, low interest rate currencies serve as insurance against solvency risk, while high interest rate currencies expose investors to more risk. The results are not attenuated by existing risks and pass a broad range of various robustness checks.

Carry Trade in Emerging Markets: Return and Macroeconomic Risks

This paper finds that currency carry trade, which is borrowing money from a low interest rate country and lending it into a high interest rate country, can generate high excess profits and high alpha in both developed and emerging markets. The profit from G-10 country carry trade is mainly from strong exchange rates, while most of the emerging markets carry trades profits are from the huge interest rate differential. Emerging market (EM) data are more favorable to the UIP hypothesis that high interest rate currency is usually depreciated, but G-10 countries are the opposite. By using quantile regression, we find that higher interest rate differential is usually associated with the exchange rate crash of the high interest rate currency. In addition, carry trade portfolios are exposed to multiple risk factors. Those factors are more significant at the low tail distribution of returns. Commodities prices and emerging market equities index positively predicted next month’s carry trade return. Liquidity condition in the U.S. is negatively related to G-10 country carry trade, but not related to emerging markets. Finally, high country risk predicted high carry trade return.

Carry Trade Incentives and Turbulence in the Foreign Exchange Market in Colombia

A currency carry trade is an investment strategy broadly used by speculators in which the investor sells low interest rate currencies (funding currencies) and uses the funds to invest in high interest rate currencies (target currencies). This paper analyzes if the carry‐to‐risk‐ratio estimated as the risk‐adjusted interest rate differential between Colombia and the United States is an appropriate indicator to identify opportunities in which carry trade strategies are more attractive to investors. The paper also studies if carry trades may cause large corrections in the Colombian peso/dollar exchange rate known in the literature as currency crash risk. The evidence indicates that the Colombian peso was attractive for carry trade in 2004, 2007, 2008 and 2012. Results from a vector autoregressive model also suggest that shocks to carry trade incentives may produce episodes of exchange rate turbulence.

Violations of uncovered interest rate parity and international exchange rate dependences

The uncovered interest rate parity puzzle questions the economic relation existing between short term interest rate differentials and exchange rates. One would indeed expect that the differential of interest rates between two countries should be offset by an opposite evolution of the exchange rate between them, hence ruling out any limited risk profit opportunities. However, it has been shown empirically that this relation is not holding and accordingly has led, over the past two decades, to the reinforcement of a well-known trading strategy in financial markets, namely the currency carry trade. This paper investigates how highly leveraged, mass speculator behaviour affects the dependence structure of currency returns. We propose a rigorous statistical modelling approach using two complementary techniques in order to demonstrate that speculative carry trade volumes are informative in both the covariance and tail dependence of high and low interest rate currency returns, whereas the price based factors previously suggested in the literature hold little explanatory power. We add a new feature to the understanding of the link between the UIP condition and the carry trade strategy, specifically attributed to the large joint exchange rate movements in high and low risk environments.

Is Carry Trade Still Profitable in Turkish Lira?

Carry trades are basically trades to take the advantage of high interest rates in one country by borrowing in a low interest country. The major risk in this type of financial investment is the currency risk. During the carry trade, the depreciation of the high interest rate currency against the low interest currency has to be avoided to protect carry trade profits, and even the principal investment. Anywhere between a small loss to a dramatic currency tail event loss is possible if not acted fast enough. Two complementary issues are examined. First one is to find out if there is an indicator that will signal the likelihood of the depreciation of the high interest rate currency (TRY) against the low interest currency (USD). REER is such an indicator signaling a possible depreciation whenever the value exceeds the important 100 level. The second part of the study focuses on the profitability of USD/TRY carry trade between 2005 and 2016 on a rolling months basis. The outcome as a whole shows positive results, but taken as two sample groups one sample covering 2005-2009, the other sample covering 2010-2016 the results are contradictory. First period is profitable while the second period produces a loss. Therefore the study concludes that USD/TRY as a carry trade is becoming increasingly less profitable despite the considerable interest rate difference between TRY and USD.

Explaining Exchange Rate Anomalies in a Model with Taylor-Rule Fundamentals and Consistent Expectations

We introduce a form of boundedly-rational expectations into a standard asset-pricing model of the exchange rate, where cross-country interest rate differentials are governed by Taylor-type rules. We postulate that agents augment a lagged-information random walk forecast with a term that relates to news about Taylor-rule fundamentals. We solve for a ?consistent expectations equilibrium,? in which the coefficient on fundamental news in the agent?s forecast rule is pinned down using the moments of observable data. The forecast errors observed by the agent are close to white noise, making it di cult for the agent to detect any misspecification. We show that the model generates volatility and persistence that is remarkably similar to that observed in monthly bilateral exchange rate data (relative to the U.S.) for Canada, Japan, and the U.K. over the period 1974 to 2012. Moreover, we show that regressions performed on model-generated data can deliver the well-documented forward premium anomaly whereby a high interest rate currency tends to appreciate, thus violating the uncovered interest rate parity condition.

System-Wide Volatility Connectedness and Carry Trades

I empirically examine the system-wide volatility connectedness risk of currencies as an explanation for the risk premium of carry trade returns. Carry trade strategies exploit the forward premium puzzle by borrowing in low interest rate currencies and investing in high interest currencies without losing the generated gain to a corresponding change in exchange rates. I find that system-wide volatility connectedness risk carries a significant and negative risk premium. That is, low interest rate currencies are positively related to system-wide volatility connectedness risk, while high interest rate currencies display a negative correlation. Low interest rate currencies thus serve as a hedge during unexpectedly high system-wide volatility connectedness episodes, indicating bad states of the world. In contrast, high interest rate currencies perform particularly poorly during these periods.

Cross-asset return predictability: Carry trades, stocks and commodities

Equity returns predict carry trade profits from shorting low interest rate currencies. Commodity price changes predict profits from longing high interest rate currencies. The gradual information diffusion hypothesis (Hong & Stein, 1999) provides a ready explanation for these predictability results. These results cannot be explained by time-varying risk premia as stock returns and commodity price changes significantly predict negative carry trade profits. The predictability is one-directional, from commodities to high interest rate currencies, from commodities to stocks and from stocks to low interest rate currencies.