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http://ssrn.com/abstract=1342968
 
 

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Carry Trades and Global Foreign Exchange Volatility


Lukas Menkhoff


Leibniz Universitaet Hannover - Department of Economics; CESifo (Center for Economic Studies and Ifo Institute)

Lucio Sarno


City University London - Sir John Cass Business School; Centre for Economic Policy Research (CEPR)

Maik Schmeling


City University London - Sir John Cass Business School

Andreas Schrimpf


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

February 28, 2011

Journal of Finance, Forthcoming
EFA 2009 Bergen Meetings Paper

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.

Number of Pages in PDF File: 93

Keywords: F31, G12, G15

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

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Date posted: February 14, 2009 ; Last revised: March 2, 2011

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: http://ssrn.com/abstract=1342968

Contact Information

Lukas Menkhoff (Contact Author)
Leibniz Universitaet Hannover - Department of Economics ( email )
Koenigsworther Platz 1
30167 Hannover
Germany
CESifo (Center for Economic Studies and Ifo Institute)
Poschinger Str. 5
Munich, DE-81679
Germany
Lucio Sarno
City University London - Sir John Cass Business School ( email )
106 Bunhill Row
London, EC1Y 8TZ
United Kingdom
Centre for Economic Policy Research (CEPR)
77 Bastwick Street
London, EC1V 3PZ
United Kingdom
Maik Schmeling
City University London - Sir John Cass Business School ( email )
106 Bunhill Row
London, EC1Y 8TZ
United Kingdom
Andreas Schrimpf
Bank for International Settlements (BIS) - Monetary and Economic Department ( email )
Centralbahnplatz 2
CH-4002 Basel
Switzerland
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