Carry and Trend Following Returns in the Foreign Exchange Market

32 Pages Posted: 22 Jul 2015

See all articles by Andrew Clare

Andrew Clare

City, University of London - Bayes Business School

James Seaton

City University London - The Business School

Peter N. Smith

University of York - Department of Economics and Related Studies; Australian National University (ANU) - Centre for Applied Macroeconomic Analysis (CAMA)

Steve Thomas

City University London - The Business School

Date Written: July 20, 2015

Abstract

Recent research has confirmed the behaviour of traders that significant excess returns can be achieved from following the predictions of the carry trade which involves buying currencies with relatively high short-term interest rates, or equivalently a high forward premium, and selling those with relatively low interest rates. This paper shows that similar-sized excess returns can be achieved by following a trend-following strategy which buys long positions in currencies that have achieved positive returns and otherwise holds cash. We demonstrate that market risk is an important determinant of carry returns but that the standard unconditional CAPM is inadequate in explaining the cross-section of forward premium ordered portfolio returns. We also show that the downside risk CAPM fails to explain this cross-section, in contrast to recent literature. A conditional CAPM which makes the impact of the market return as a risk factor depend on a measure of market liquidity performs very well in explaining more than 90% of the variation in portfolio returns and more than 90% of the average returns to the carry trade. Trend following is found to provide a significant hedge against these risks. The performance of the trend following factor is more surprising given that it does not have the negative skewness or maximum drawdown characteristic which is shown by the carry trade factor.

Keywords: Forward exchange rate returns, trend following, carry trade, market liquidity and exchange risk.

JEL Classification: F31, G12, G11, G15

Suggested Citation

Clare, Andrew D. and Seaton, James and Smith, Peter N. and Thomas, Stephen H., Carry and Trend Following Returns in the Foreign Exchange Market (July 20, 2015). Available at SSRN: https://ssrn.com/abstract=2633752 or http://dx.doi.org/10.2139/ssrn.2633752

Andrew D. Clare

City, University of London - Bayes Business School ( email )

106, Bunhill Row
London, EC1Y 8TZ
United Kingdom

James Seaton

City University London - The Business School ( email )

106 Bunhill Row
London, EC1Y 8TZ
United Kingdom

Peter N. Smith (Contact Author)

University of York - Department of Economics and Related Studies ( email )

Heslington
York 010 5DD
United Kingdom
+44 1904 433 765 (Phone)
+44 1904 433 759 (Fax)

Australian National University (ANU) - Centre for Applied Macroeconomic Analysis (CAMA) ( email )

ANU College of Business and Economics
Canberra, Australian Capital Territory 0200
Australia

Stephen H. Thomas

City University London - The Business School ( email )

106 Bunhill Row
London, EC1Y 8TZ
United Kingdom
+44 (0) 20 7040 5271 (Phone)
+44 (0) 20 7040 8881 (Fax)

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