Foreign Exchange Risk and the Predictability of Carry Trade Returns

34 Pages Posted: 3 May 2012 Last revised: 5 Feb 2014

See all articles by Gino Cenedese

Gino Cenedese

Fulcrum Asset Management

Lucio Sarno

City University London - Sir John Cass Business School; Centre for Economic Policy Research (CEPR)

Ilias Tsiakas

University of Guelph

Date Written: February 4, 2014

Abstract

This paper provides an empirical investigation of the time-series predictive ability of foreign exchange risk measures on the return to the carry trade, a popular investment strategy that borrows in low-interest currencies and lends in high-interest currencies. Using quantile regressions, we find that higher market variance is significantly related to large future carry trade losses, which is consistent with the unwinding of the carry trade in times of high volatility. The decomposition of market variance into average variance and average correlation shows that the predictive power of market variance is primarily due to average variance since average correlation is not significantly related to carry trade returns. Finally, a new version of the carry trade that conditions on market variance generates performance gains net of transaction costs.

Keywords: Exchange Rates, Carry Trade, Market Variance, Average Variance, Average Correlation, Quantile Regression

JEL Classification: F31, G15, G17

Suggested Citation

Cenedese, Gino and Sarno, Lucio and Tsiakas, Ilias, Foreign Exchange Risk and the Predictability of Carry Trade Returns (February 4, 2014). Available at SSRN: https://ssrn.com/abstract=2050106 or http://dx.doi.org/10.2139/ssrn.2050106

Gino Cenedese

Fulcrum Asset Management ( email )

66 Seymour Street
London, W1H 5BT
United Kingdom

Lucio Sarno (Contact Author)

City University London - Sir John Cass Business School ( email )

106 Bunhill Row
London, EC1Y 8TZ
United Kingdom

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Ilias Tsiakas

University of Guelph ( email )

Department of Economics and Finance
University of Guelph
Guelph, Ontario N1G 2W1
Canada
5198244120 ext 53054 (Phone)
5197638497 (Fax)

HOME PAGE: http://www.uoguelph.ca/~itsiakas

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