Carry Trades and Global Foreign Exchange Volatility

93 Pages Posted: 14 Feb 2009 Last revised: 2 Mar 2011

See all articles by Lukas Menkhoff

Lukas Menkhoff

Kiel Institute for the World Economy; German Institute for Economic Research (DIW Berlin); Humboldt-Universität zu Berlin

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

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Date Written: February 28, 2011

Abstract

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.

Keywords: F31, G12, G15

JEL Classification: Carry Trade, Volatility, Liquidity, Forward Premiu

Suggested Citation

Menkhoff, Lukas and Sarno, Lucio and Schmeling, Maik and Schrimpf, Andreas, Carry Trades and Global Foreign Exchange Volatility (February 28, 2011). Journal of Finance, Forthcoming, EFA 2009 Bergen Meetings Paper, Available at SSRN: https://ssrn.com/abstract=1342968

Lukas Menkhoff (Contact Author)

Kiel Institute for the World Economy ( email )

P.O. Box 4309
Kiel, Schleswig-Hosltein D-24100
Germany

German Institute for Economic Research (DIW Berlin) ( email )

Mohrenstraße 58
Berlin, 10117
Germany

Humboldt-Universität zu Berlin ( email )

Humboldt Universität
Unter den Linden 6
Berlin, 10099
Germany

Lucio Sarno

University of Cambridge - Judge Business School ( email )

Trumpington Street
Cambridge, CB2 1AG
United Kingdom

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Maik Schmeling

Goethe University Frankfurt - Department of Finance ( email )

House of Finance
Theodor-W.-Adorno-Platz 3
Frankfurt am Main, Hessen 60323
Germany

HOME PAGE: http://sites.google.com/site/maikschmeling/

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Andreas Schrimpf

Bank for International Settlements (BIS) - Monetary and Economic Department ( email )

Centralbahnplatz 2
CH-4002 Basel
Switzerland

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

University of Tuebingen ( email )

Wilhelmstr. 19
72074 Tuebingen, Baden Wuerttemberg 72074
Germany

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