The Time-Varying Systematic Risk of Carry Trade Strategies
University of Aarhus - School of Economics and Management - CREATES
University of St. Gallen
University of St. Gallen; Centre for Economic Policy Research (CEPR)
February 3, 2010
Journal of Financial and Quantitative Analysis (JFQA), Forthcoming
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, G11working papers series
Date posted: April 23, 2009 ; Last revised: February 6, 2010
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