Foreign exchange risk and the predictability of carry trade returns

• Published in: Journal of banking & finance Vol. 42; pp. 302 - 313
• Main Authors: Cenedese, Gino, Sarno, Lucio, Tsiakas, Ilias
• Format: Journal Article
• Language: English
• Published: Amsterdam Elsevier B.V 01.05.2014; Elsevier Sequoia S.A
• Subjects: Average correlation; Average variance; Carry trade; Correlation; Currency transactions; Exchange rates; Foreign exchange; Foreign exchange rate risk; Investment policy; Long term; Market variance; Quantile regression; Rates of return; Regression analysis; Studies; Time series; Transaction costs; Variance analysis; Exchange rates; Average variance; Market variance; F31; Average correlation; G15; G17; Carry trade; Quantile regression
• ISSN: 0378-4266; 1872-6372
• DOI: 10.1016/j.jbankfin.2014.01.040

This paper provides an empirical investigation of the time-series predictive ability of foreign exchange risk measures on the return to the carry trade, a popular investment strategy that borrows in low-interest currencies and lends in high-interest currencies. Using quantile regressions, we find that higher market variance is significantly related to large future carry trade losses, which is consistent with the unwinding of the carry trade in times of high volatility. The decomposition of market variance into average variance and average correlation shows that the predictive power of market variance is primarily due to average variance since average correlation is not significantly related to carry trade returns. Finally, a new version of the carry trade that conditions on market variance generates performance gains net of transaction costs.