Last Updated on 10 February, 2024 by Rejaul Karim
The paper “Carry and Trend Following Returns in the Foreign Exchange Market” offers a captivating foray into the realm of currency market dynamics, shedding light on the extraordinary potential for achieving significant excess returns through carry and trend-following strategies.
The profound insights of recent research have underscored the efficacy of the carry trade, leveraging high short-term interest rates or forward premia, to yield substantial excess returns.
Remarkably, this study uncovers that an equivalent level of excess returns can be realized by utilizing a trend-following strategy, buying long positions in currencies that have accrued positive returns, while holding cash otherwise.
Notably, the paper delves into the pivotal role of market risk as a determinant of carry returns, underscored by the inadequacy of the standard unconditional CAPM in explaining the cross-section of forward premium ordered portfolio returns.
Additionally, the conditional CAPM, contingent on market liquidity, emerges as a strong contender in explicating the variation and average returns of the carry trade.
Furthermore, this comprehensive analysis reveals trend following as a substantial hedge against the risks inherent in carry trade, affirmed by its ability to mitigate market risk without exhibiting the characteristic negative skewness or maximum drawdown.
These findings promise to significantly invigorate our understanding of forward exchange rate returns, trend following, market liquidity, and exchange risk, thereby enriching the ongoing discourse on investment strategies and currency market dynamics.
Abstract Of Paper
Recent research has confirmed the behaviour of traders that significant excess returns can be achieved from following the predictions of the carry trade which involves buying currencies with relatively high short-term interest rates, or equivalently a high forward premium, and selling those with relatively low interest rates. This paper shows that similar-sized excess returns can be achieved by following a trend-following strategy which buys long positions in currencies that have achieved positive returns and otherwise holds cash. We demonstrate that market risk is an important determinant of carry returns but that the standard unconditional CAPM is inadequate in explaining the cross-section of forward premium ordered portfolio returns. We also show that the downside risk CAPM fails to explain this cross-section, in contrast to recent literature. A conditional CAPM which makes the impact of the market return as a risk factor depend on a measure of market liquidity performs very well in explaining more than 90% of the variation in portfolio returns and more than 90% of the average returns to the carry trade. Trend following is found to provide a significant hedge against these risks. The performance of the trend following factor is more surprising given that it does not have the negative skewness or maximum drawdown characteristic which is shown by the carry trade factor.
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City, University of London – Bayes Business School
City University London – The Business School
Peter N. Smith
University of York – Department of Economics and Related Studies; Australian National University (ANU) – Centre for Applied Macroeconomic Analysis (CAMA)
City University London – The Business School
In conclusion, “Carry and Trend Following Returns in the Foreign Exchange Market” presents a compelling panorama of the remarkable potential for achieving substantial excess returns through the prism of the carry trade and trend-following strategies.
The empirical affirmation of sizeable excess returns attainable through the carry trade, predicated on buying currencies with high short-term interest rates or forward premia, has laid the foundation for a paradigm shift in investment strategies.
Equally noteworthy is the revelation that a parallel magnitude of excess returns can be garnered through a trend-following approach, purchasing long positions in currencies with positive returns while holding cash elsewhere.
The study’s illumination of the critical influence of market risk on carry returns, intertwined with the inadequacy of the standard unconditional CAPM, underscores the complexity of the foreign exchange market.
Moreover, the efficacy of a conditional CAPM tethered to market liquidity emerges as a potent explanatory framework for the variation and average returns of the carry trade, accentuating its pivotal role in the investment landscape.
Notably, the insight that trend following offers a substantial hedge against these risks, despite not exhibiting the negative skewness or maximum drawdown characteristic of the carry trade factor, marks a significant stride in investment strategy innovation.
These findings hold notable promise in advancing our comprehension of forward exchange rate returns, trend following, market liquidity, and their implications for exchange risk, offering a rich tapestry of insights into the dynamics of the currency market.
Q1: What are the main findings of the research paper “Carry and Trend Following Returns in the Foreign Exchange Market”?
A1: The research paper uncovers significant potential for achieving excess returns through both carry and trend-following strategies in the foreign exchange market. It highlights that substantial excess returns can be realized not only through the traditional carry trade, based on short-term interest rates or forward premia, but also through a trend-following strategy. The latter involves buying long positions in currencies with positive returns while holding cash elsewhere.
Q2: What role does market risk play in determining carry returns, according to the paper?
A2: Market risk is identified as a crucial determinant of carry returns. The paper emphasizes the inadequacy of the standard unconditional Capital Asset Pricing Model (CAPM) in explaining the cross-section of forward premium ordered portfolio returns. It suggests that market risk, especially when conditioned on market liquidity, plays a significant role in elucidating the variation and average returns of the carry trade.
Q3: How does trend following act as a hedge against risks in the foreign exchange market?
A3: The paper reveals that trend following serves as a substantial hedge against risks in the foreign exchange market. Despite not exhibiting the negative skewness or maximum drawdown characteristic of the carry trade factor, trend following is shown to effectively mitigate market risk. This finding adds a layer of resilience and risk management potential to the overall investment strategy landscape in the foreign exchange market.