Carry Trades and Global Foreign Exchange Volatility
Leibniz Universitaet Hannover - Department of Economics; CESifo (Center for Economic Studies and Ifo Institute)
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
CEPR Discussion Paper No. DP8291
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: 95
Keywords: carry trade, forward premium puzzle, liquidity, volatility
JEL Classification: F31, G12, G15working papers series
Date posted: March 28, 2011
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