Predictability of Currency Carry Trades and Asset Pricing Implications

54 Pages Posted: 30 Dec 2011  

Gurdip Bakshi

University of Maryland - Robert H. Smith School of Business

George Panayotov

Hong Kong University of Science & Technology (HKUST)

Date Written: November 11, 2011

Abstract

This paper studies the time-series predictability of currency carry trades, constructed by selecting currencies to be bought or sold against the U.S. dollar, based on forward discounts. Changes in a commodity index, currency volatility and, to a lesser extent, a measure of liquidity predict in-sample the payoffs of dynamically re-balanced carry trades, as evidenced by individual and joint p-values in monthly predictive regressions at horizons up to six months. Predictability is further supported through out-of-sample metrics, and a predictability-based decision rule produces sizeable improvements in the Sharpe ratios and skewness profile of carry trade payoffs. Our evidence also indicates that predictability can be traced to the long legs of the carry trades and their currency components. We test the theoretical restrictions that an asset pricing model, with average currency returns and the mimicking portfolio for the innovations in currency volatility as risk factors, imposes on the coefficients in predictive regressions.

Keywords: currency carry trades, predictability

JEL Classification: G12, F31

Suggested Citation

Bakshi, Gurdip and Panayotov, George, Predictability of Currency Carry Trades and Asset Pricing Implications (November 11, 2011). Available at SSRN: https://ssrn.com/abstract=1977642 or http://dx.doi.org/10.2139/ssrn.1977642

Gurdip S. Bakshi

University of Maryland - Robert H. Smith School of Business ( email )

Department of Finance
College Park, MD 20742-1815
United States
301-405-2261 (Phone)
301-314-9157 (Fax)

HOME PAGE: http://scholar.rhsmith.umd.edu/gbakshi/Home?destination=Home

George Panayotov (Contact Author)

Hong Kong University of Science & Technology (HKUST) ( email )

Clearwater Bay
Kowloon
Hong Kong
852-2358-5049 (Phone)
852-2358-1749 (Fax)

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