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Predictability of Currency Carry Trades and Asset Pricing Implications

Last Updated on 10 February, 2024 by Rejaul Karim

The research paper “Predictability of Currency Carry Trades and Asset Pricing Implications” by Gurdip Bakshi and George Panayotov delves into the complex realm of currency carry trades and their predictability, offering compelling insights into the dynamics of these investments and their asset pricing implications.

By analyzing the time-series predictability of currency carry trades, particularly those involving currencies bought or sold against the U.S. dollar based on forward discounts, the study identifies changes in a commodity index, currency volatility, and liquidity as key predictors of the payoffs of dynamically re-balanced carry trades.

The paper not only establishes the in-sample predictability of these trades but also validates its findings through out-of-sample metrics, culminating in a predictability-based decision rule that significantly enhances the Sharpe ratios and skewness profile of carry trade payoffs.

Additionally, the examination of theoretical restrictions imposed on the coefficients in predictive regressions provides a compelling exploration of the asset pricing model. This research not only advances our understanding of currency carry trades’ predictability but also promises far-reaching implications for asset pricing in financial markets.

Abstract Of Paper

This paper studies the time-series predictability of currency carry trades, constructed by selecting currencies to be bought or sold against the U.S. dollar, based on forward discounts. Changes in a commodity index, currency volatility and, to a lesser extent, a measure of liquidity predict in-sample the payoffs of dynamically re-balanced carry trades, as evidenced by individual and joint p-values in monthly predictive regressions at horizons up to six months. Predictability is further supported through out-of-sample metrics, and a predictability-based decision rule produces sizeable improvements in the Sharpe ratios and skewness profile of carry trade payoffs. Our evidence also indicates that predictability can be traced to the long legs of the carry trades and their currency components. We test the theoretical restrictions that an asset pricing model, with average currency returns and the mimicking portfolio for the innovations in currency volatility as risk factors, imposes on the coefficients in predictive regressions.

Original paper – Download PDF

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Author

Gurdip Bakshi
Fox School of Business; Temple University – Fox School of Business and Management

George Panayotov
Hong Kong University of Science & Technology (HKUST)

Conclusion

In conclusion, “Predictability of Currency Carry Trades and Asset Pricing Implications” by Gurdip Bakshi and George Panayotov offers a compelling exploration of the predictability of currency carry trades and its far-reaching asset pricing implications.

The research illuminates the robust predictability of carry trades through changes in a commodity index, currency volatility, and liquidity, validating these findings with in-sample predictive regressions and out-of-sample metrics.

The development of a predictability-based decision rule not only demonstrates significant enhancements in the Sharpe ratios and skewness profile of carry trade payoffs but also underscores the pivotal role of predictability in improving investment outcomes.

The study’s attribution of predictability to the long legs of carry trades and their currency components further enriches our understanding of these trades’ dynamics.

Moreover, the testing of theoretical restrictions imposed by an asset pricing model provides a comprehensive assessment of the implications for asset pricing in financial markets. Overall, this research not only advances our comprehension of currency carry trades but also establishes their predictability as a critical factor with profound impacts on asset pricing dynamics.

Related Reading:

A Credit-Based Theory of the Currency Risk Premium

Foreign Exchange Risk and the Predictability of Carry Trade Returns

FAQ

Q1: What is the main focus of the research paper “Predictability of Currency Carry Trades and Asset Pricing Implications” by Gurdip Bakshi and George Panayotov?

A1: The main focus of the research paper is the time-series predictability of currency carry trades, specifically those involving currencies bought or sold against the U.S. dollar based on forward discounts. The study aims to identify key predictors of the payoffs of dynamically re-balanced carry trades and explores the implications of this predictability on asset pricing in financial markets.

Q2: What are the key predictors of the payoffs of currency carry trades identified in the study?

A2: The study identifies changes in a commodity index, currency volatility, and, to a lesser extent, a measure of liquidity as key predictors of the payoffs of dynamically re-balanced currency carry trades. These factors are found to have predictive power for the in-sample performance of carry trades.

Q3: How does the paper validate the predictability of currency carry trades?

A3: The paper validates the predictability of currency carry trades through in-sample metrics, such as individual and joint p-values in monthly predictive regressions at horizons up to six months. Additionally, the study provides out-of-sample metrics to support the evidence of predictability.

You can find many more Research Papers here

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