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The Time-Varying Systematic Risk of Carry Trade StrategiesCharlotte ChristiansenUniversity of Aarhus - School of Economics and Management - CREATES Angelo RanaldoUniversity of St. Gallen Paul SöderlindUniversity of St. Gallen; Centre for Economic Policy Research (CEPR) February 3, 2010 Journal of Financial and Quantitative Analysis (JFQA), Forthcoming Abstract: We explain the currency carry trade performance using an asset pricing model in which factor loadings are regime-dependent rather than constant. Empirical results show that a typical carry trade strategy has much higher exposure to the stock market and is mean-reverting in regimes of high FX volatility. The findings are robust to various extensions. Our regime-dependent pricing model provides significantly smaller pricing errors than a traditional model. Thus, the carry trade performance is better explained by a time-varying systematic risk that increases in volatile markets, suggesting a partial resolution of the Uncovered Interest Rate parity puzzle.
Number of Pages in PDF File: 26 Keywords: carry trade, factor model, FX volatility, liquidity, smooth transition regression, time-varying betas JEL Classification: F31, G15, G11 working papers seriesDate posted: April 23, 2009 ; Last revised: February 6, 2010Suggested CitationContact Information
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