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Cross-Asset Return Predictability: Carry Trades, Stocks and Commodities

Last Updated on 10 February, 2024 by Rejaul Karim

Within the research paper “Cross-Asset Return Predictability: Carry Trades, Stocks, and Commodities” authored by Helen Lu and Ben Jacobsen, an in-depth analysis is presented on the interconnectivity between equity returns and commodity price changes in predicting carry trade profits.

The study examines the predictive power of commodity price changes and equity returns on the profitability of both high and low-interest rate currencies.

Notably, the authors find that equity returns and commodity price changes have a significant impact on carry trades, with equity returns predicting short leg profits from shorting low-interest rate currencies.

This comprehensive analysis sheds light on the interplay between various asset classes and their influence on carry trade profitability.

Abstract Of Paper

Bakshi and Panayotov (2013) find that commodity price changes predict profits from longing high interest rate currencies (long leg profits) up to three months later. We find that equity returns also predict carry trade profits, but from shorting low interest rate currencies (short leg profits). Equity effects appear to be slightly faster than commodity effects, as equity price rises predict higher short leg profits over the next two months. The predictability is one-directional from commodities and stocks to carry trades. Our evidence supports gradual information diffusion, rather than time-varying risk premia, as the most likely explanation for the predictability results.

Original paper – Download PDF

Here you can download the PDF and original paper of Cross-Asset Return Predictability: Carry Trades, Stocks and Commodities.

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Author

Helen Lu
University of Auckland Business School; University of Auckland – Department of Accounting and Finance

Ben Jacobsen
Tilburg University – TIAS School for Business and Society; Massey University

Conclusion

The findings elucidated in the research paper regarding the predictive power of equity returns and commodity price changes on carry trade profits hold significant implications for financial markets.
The evidence supporting the one-directional predictability from commodities and stocks to carry trades provides valuable insights into gradual information diffusion.

This challenges the conventional wisdom of time-varying risk premia as the explanation for the predictability results.

The discoveries made in this study have the potential to influence trading strategies and provide a deeper understanding of the interconnectedness between different asset classes in forecasting carry trade profits.

Related Reading:

Off the Golden Fetters: Examining Interwar Carry Trade and Momentum

The Carry Trade: Risks and Drawdowns

FAQ

Q1: What are the key findings of the research paper “Cross-Asset Return Predictability: Carry Trades, Stocks, and Commodities”?

A1: The research paper finds that commodity price changes and equity returns have a significant impact on carry trades. Specifically, equity returns predict carry trade profits, particularly short leg profits from shorting low-interest rate currencies. The predictive power of equity returns is observed to be slightly faster than commodity effects, with equity price rises predicting higher short leg profits over the next two months. The evidence suggests gradual information diffusion, challenging the conventional explanation of time-varying risk premia.

Q2: How does the paper contribute to the understanding of carry trade profitability and asset interconnectivity?

A2: The paper contributes by examining the interconnectivity between equity returns, commodity price changes, and carry trade profitability. The findings provide insights into the dynamics of asset classes and their impact on carry trades. The one-directional predictability from commodities and stocks to carry trades suggests that information diffusion plays a crucial role in forecasting carry trade profits. This challenges the conventional explanation of time-varying risk premia and enhances our understanding of the interconnectedness between different asset classes.

Q3: What are the implications of the research findings for trading strategies and financial markets?

A3: The research findings have implications for trading strategies, suggesting that incorporating information from equity returns and commodity price changes can be valuable in forecasting carry trade profits. The evidence of gradual information diffusion challenges existing notions of time-varying risk premia, potentially influencing how traders and investors approach carry trade strategies. The study enhances our understanding of the relationships between different asset classes and their impact on financial markets.

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