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The Time-Varying Systematic Risk of Carry Trade Strategies

26 Pages Posted: 23 Apr 2009 Last revised: 11 Jun 2013

Charlotte Christiansen

Aarhus University - CREATES

Angelo Ranaldo

University of St. Gallen; University of St. Gallen - School of Finance

Paul Söderlind

University of St. Gallen; Centre for Economic Policy Research (CEPR); University of St. Gallen - School of Finance

Multiple version iconThere are 3 versions of this paper

Date Written: February 3, 2010

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.

Keywords: carry trade, factor model, FX volatility, liquidity, smooth transition regression, time-varying betas

JEL Classification: F31, G15, G11

Suggested Citation

Christiansen, Charlotte and Ranaldo, Angelo and Söderlind, Paul, The Time-Varying Systematic Risk of Carry Trade Strategies (February 3, 2010). Journal of Financial and Quantitative Analysis (JFQA), Forthcoming. Available at SSRN: https://ssrn.com/abstract=1392764 or http://dx.doi.org/10.2139/ssrn.1392764

Charlotte Christiansen

Aarhus University - CREATES ( email )

Fuglesangs Alle 4
Aarhus V, DK 8210
Denmark

Angelo Ranaldo (Contact Author)

University of St. Gallen ( email )

Swiss Institute of Banking and Finance s/bf-HSG
Unterer Graben 21
St. Gallen, 9000
Switzerland
+41712247010 (Phone)

HOME PAGE: http://www.sbf.unisg.ch/Lehrstuehle/Lehrstuhl_Ranaldo/Homepage_Ranaldo.aspx

University of St. Gallen - School of Finance ( email )

Unterer Graben 21
St.Gallen, CH-9000
Switzerland

Paul Söderlind

University of St. Gallen ( email )

Rosenbergstrasse 52
St. Gallen, 9000
Switzerland
+41 71 224 7064 (Phone)
+41 71 224 7088 (Fax)

HOME PAGE: http://https://sites.google.com/site/paulsoderlindecon/home

Centre for Economic Policy Research (CEPR)

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

University of St. Gallen - School of Finance ( email )

Unterer Graben 21
St.Gallen, CH-9000
Switzerland

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