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Carry Trades and Global Foreign Exchange Volatility

93 Pages Posted: 14 Feb 2009 Last revised: 2 Mar 2011

Lukas Menkhoff

German Institute for Economic Research (DIW Berlin); Humboldt University of Berlin - Faculty of Economics

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; Centre for Economic Policy Research (CEPR)

Andreas Schrimpf

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

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Date Written: February 28, 2011

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.

Keywords: F31, G12, G15

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

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

Lukas Menkhoff (Contact Author)

German Institute for Economic Research (DIW Berlin) ( email )

Mohrenstra├če 58
Berlin, 10117
Germany

Humboldt University of Berlin - Faculty of Economics ( email )

Spandauer Strasse 1
Berlin
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

Centre for Economic Policy Research (CEPR) ( email )

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

Andreas Schrimpf

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

Centralbahnplatz 2
CH-4002 Basel
Switzerland

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