Swing Trading Signals


Since 2013

  • 100% Quantified, data-driven and Backtested
  • We always show our results!
  • Signals every day via our site or email
  • Cancel at any time!

Carry Trades and Global Foreign Exchange Volatility

Last Updated on 10 February, 2024 by Rejaul Karim

The research paper “Carry Trades and Global Foreign Exchange Volatility” by Lukas Menkhoff, Lucio Sarno, Maik Schmeling, and Andreas Schrimpf delves into the intricate relationship between global foreign exchange (FX) volatility risk and the cross-section of excess returns originating from popular carry trade strategies.

These strategies entail borrowing in low-interest rate currencies and investing in high-interest rate currencies. The study markedly uncovers that high-interest rate currencies exhibit a negative correlation with innovations in global FX volatility, leading to reduced returns during periods of unforeseen high volatility, while low-interest rate currencies offer a hedge by yielding positive returns.

Notably, the research’s proxy for global FX volatility risk encapsulates over 90% of the cross-sectional excess returns across five carry trade portfolios, signaling an economically substantial risk-return relation in the FX market.

Furthermore, the authors’ analysis reveals that liquidity risk holds relevance for expected FX returns, albeit to a lesser extent than volatility risk. The profound insights gleaned from the study’s findings substantially contribute to our understanding of risk-return dynamics and have wider implications across foreign exchange, U.S. equity, and corporate bond markets.

Abstract Of Paper

We investigate the relation between global foreign exchange (FX) volatility risk and the cross-section of excess returns arising from popular strategies that borrow in low-interest rate currencies and invest in high-interest rate currencies, so-called ‘carry trades’. We find that high interest rate currencies are negatively related to innovations in global FX volatility and thus deliver low returns in times of unexpected high volatility, when low interest rate currencies provide a hedge by yielding positive returns. Our proxy for global FX volatility risk captures more than 90% of the cross-sectional excess returns in five carry trade portfolios. In turn, these results provide evidence that there is an economically meaningful risk-return relation in the FX market. Further analysis shows that liquidity risk also matters for expected FX returns, but to a lesser degree than volatility risk. Finally, exposure to our volatility risk proxy also performs well for pricing returns of other cross sections in foreign exchange, U.S. equity, and corporate bond markets.

Original paper – Download PDF

Here you can download the PDF and original paper of Carry Trades and Global Foreign Exchange Volatility.

(An option to download will come shortly)

Author

Lukas Menkhoff
German Institute for Economic Research (DIW Berlin); Humboldt University of Berlin – Faculty of Economics

Lucio Sarno
University of Cambridge – Judge Business School; Centre for Economic Policy Research (CEPR)

Maik Schmeling
Goethe University Frankfurt – Department of Finance; Centre for Economic Policy Research (CEPR)

Andreas Schrimpf
Bank for International Settlements (BIS) – Monetary and Economic Department; Centre for Economic Policy Research (CEPR); University of Tuebingen

Conclusion

In conclusion, the research paper “Carry Trades and Global Foreign Exchange Volatility” authored by Lukas Menkhoff, Lucio Sarno, Maik Schmeling, and Andreas Schrimpf delivers a comprehensive and revelatory analysis of the interplay between global FX volatility risk and the cross-section of excess returns resulting from carry trade strategies.
The study’s profound insights portray high interest rate currencies as being adversely impacted by innovations in global FX volatility, culminating in diminished returns during periods of unexpected high volatility, as opposed to low-interest rate currencies, which provide a risk-mitigating hedge by generating positive returns.

The research’s proxy for global FX volatility risk emerges as a pivotal determinant, capturing a significant portion of the cross-sectional excess returns in five carry trade portfolios, thereby establishing an economically substantial risk-return relationship in the FX market.

Additionally, the study’s analysis underscores the relevance of liquidity risk in shaping expected FX returns, albeit to a lesser extent than volatility risk. These findings yield profound implications across foreign exchange, U.S. equity, and corporate bond markets, enriching our comprehension of risk-return dynamics and offering valuable insights for investors and policymakers alike.

Related Reading:

Volatility Risk Premia and Exchange Rate Predictability

Is There Momentum or Reversal in Weekly Currency Returns?

FAQ

Q1: What is the main focus of the research paper “Carry Trades and Global Foreign Exchange Volatility”?

A1: The main focus of the research paper is to investigate the relationship between global foreign exchange (FX) volatility risk and the cross-section of excess returns arising from carry trade strategies. Carry trades involve borrowing in low-interest rate currencies and investing in high-interest rate currencies. The study aims to understand how high and low-interest rate currencies are affected by global FX volatility and how this impacts their returns.

Q2: What does the research find regarding the relationship between high-interest rate currencies and global FX volatility?

A2: The research finds that high-interest rate currencies exhibit a negative correlation with innovations in global FX volatility. As a result, these currencies deliver low returns during periods of unexpected high volatility. In contrast, low-interest rate currencies provide a hedge by yielding positive returns during such periods.

Q3: What proportion of cross-sectional excess returns in carry trade portfolios does the proxy for global FX volatility risk capture?

A3: The proxy for global FX volatility risk used in the research captures more than 90% of the cross-sectional excess returns in five carry trade portfolios. This suggests that global FX volatility risk is a significant determinant of returns in carry trade strategies.

Check The Leading Resource On The Internet For Research And Academic Papers

Leave a Reply

{"email":"Email address invalid","url":"Website address invalid","required":"Required field missing"}

Monthly Trading Strategy Club

$42 Per Strategy

>

Login to Your Account



Signup Here
Lost Password