The Time-Varying Systematic Risk of Carry Trade Strategies
35 Pages Posted: 14 Mar 2010
Date Written: February 5, 2010
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 trades, factor model, FX volatility, liquidity, smooth transition regression, time-varying betas
JEL Classification: F31, G15, G11
Suggested Citation: Suggested Citation