Foreign Exchange Predictability During the Financial Crisis: Implications for Carry Trade Profitability

30 Pages Posted: 20 Nov 2015  

Stanislav Anatolyev

New Economic School; CERGE-EI

Nikolay Gospodinov

Federal Reserve Bank of Atlanta

Ibrahim Jamali

American University of Beirut

Xiaochun Liu

University of Central Arkansas

Date Written: August 1, 2015

Abstract

In this paper, we study the effectiveness of carry trade strategies during and after the financial crisis using a flexible approach to modeling currency returns. We decompose the currency returns into multiplicative sign and absolute return components, which exhibit much greater predictability than raw returns. We allow the two components to respond to currency-specific risk factors and use the joint conditional distribution of these components to obtain forecasts of future carry trade returns. Our results suggest that the decomposition model produces higher forecast and directional accuracy than any of the competing models. We show that the forecasting gains translate into economically and statistically significant (risk-adjusted) profitability when trading individual currencies or forming currency portfolios based on the predicted returns from the decomposition model.

Keywords: exchange rate forecasting, carry trade, positions of traders, return decomposition, copula, joint predictive distribution

JEL Classification: F31, F37, C32, C53, G15

Suggested Citation

Anatolyev, Stanislav and Gospodinov, Nikolay and Jamali, Ibrahim and Liu, Xiaochun, Foreign Exchange Predictability During the Financial Crisis: Implications for Carry Trade Profitability (August 1, 2015). FRB Atlanta Working Paper 2015-6. Available at SSRN: https://ssrn.com/abstract=2692761

Stanislav A. Anatolyev

New Economic School ( email )

47 Nakhimovsky Prospekt
Moscow, 117418
Russia

CERGE-EI ( email )

P.O. Box 882
7 Politickych veznu
Prague 1, 111 21
Czech Republic

Nikolay Gospodinov (Contact Author)

Federal Reserve Bank of Atlanta ( email )

Atlanta, GA 30309
United States

HOME PAGE: https://www.frbatlanta.org/research/economists/gospodinov-nikolay.aspx?panel=1

Ibrahim Jamali

American University of Beirut ( email )

Xiaochun Liu

University of Central Arkansas ( email )

Conway, AR 72035-0001
United States

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