Carry Trades and Global Foreign Exchange Volatility
German Institute for Economic Research (DIW Berlin); Humboldt University of Berlin - Faculty of Economics
City University London - Sir John Cass Business School; Centre for Economic Policy Research (CEPR)
City University London - Sir John Cass Business School
Bank for International Settlements (BIS) - Monetary and Economic Department
February 28, 2011
Journal of Finance, Forthcoming
EFA 2009 Bergen Meetings Paper
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
Date posted: February 14, 2009 ; Last revised: March 2, 2011
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