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Foreign Exchange Risk and the Predictability of Carry Trade Returns

Last Updated on 10 February, 2024 by Rejaul Karim

The paper “Foreign Exchange Risk and the Predictability of Carry Trade Returns” by Gino Cenedese, Lucio Sarno, and Ilias Tsiakas conducts an empirical exploration into the time-series predictive capacity of foreign exchange risk measures on carry trade returns, a prominent investment strategy involving borrowing in low-interest currencies and lending in high-interest currencies.

Employing quantile regressions, the study uncovers a significant association between higher market variance and substantial future carry trade losses, indicative of the unwinding of carry trades during periods of heightened volatility.

Furthermore, the dissection of market variance into average variance and average correlation reveals that the predictive power primarily stems from average variance, with average correlation displaying no significant relationship with carry trade returns.

Notably, the introduction of a modified carry trade approach, conditioned on market variance, yields performance gains net of transaction costs. This research not only enhances our understanding of exchange rate predictability but also offers practical insights into optimizing investment strategies under varying market conditions, thereby contributing to more informed decision-making in the realm of foreign exchange risk.

Abstract Of Paper

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.

Original paper – Download PDF

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Author

Gino Cenedese
Fulcrum Asset Management

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

Ilias Tsiakas
University of Guelph

Conclusion

In conclusion, “Foreign Exchange Risk and the Predictability of Carry Trade Returns” by Gino Cenedese, Lucio Sarno, and Ilias Tsiakas elucidates the nuanced relationship between foreign exchange risk measures and the predictability of carry trade returns, shedding light on crucial dynamics within the realm of investment strategies.

Through the employment of quantile regressions, the study notably establishes a significant link between higher market variance and substantial future carry trade losses, underscoring the unwinding of carry trades during periods characterized by heightened volatility.

Moreover, the dissection of market variance into average variance and average correlation outlines that the predictive power predominantly originates from average variance, with average correlation displaying no substantial connection with carry trade returns.

Notably, the introduction of a modified carry trade approach, conditioned on market variance, delivers performance gains net of transaction costs, indicative of the practical implications arising from this research.

This comprehensive investigation not only enriches our understanding of exchange rate predictability but also offers actionable insights for optimizing investment strategies amid varying market conditions, thereby contributing to more informed decision-making in navigating foreign exchange risk.

Related Reading:

Empirical Evidence on the Currency Carry Trade, 1900-2012

Common Risk Factors in Currency Markets

FAQ

Q1: What is the key finding regarding the relationship between foreign exchange risk and carry trade returns in the paper “Foreign Exchange Risk and the Predictability of Carry Trade Returns”?

A1: The paper finds a significant association between higher market variance and substantial future carry trade losses, indicating that increased market volatility is related to the unwinding of carry trades. This key finding highlights the predictive capacity of foreign exchange risk measures, specifically market variance, on the return to the carry trade strategy.

Q2: How does the study decompose market variance, and what role does average variance and average correlation play in predicting carry trade returns?

A2: The study decomposes market variance into average variance and average correlation. The results reveal that the predictive power of market variance primarily stems from average variance, whereas average correlation does not exhibit a significant relationship with carry trade returns. This decomposition provides insights into the specific components of market variance that are influential in predicting the performance of carry trade strategies.

Q3: What practical implications are derived from the introduction of a modified carry trade approach conditioned on market variance, and how does it perform in terms of transaction costs?

A3: The introduction of a modified carry trade approach, conditioned on market variance, generates performance gains net of transaction costs. This suggests that considering market variance in the design of carry trade strategies can lead to improved outcomes. The practical implication is that investors and practitioners can enhance their investment strategies by incorporating insights from foreign exchange risk measures, particularly during periods of varying market conditions, ultimately contributing to more informed decision-making in the domain of foreign exchange risk.

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