System-Wide Volatility Connectedness and Carry Trades

53 Pages Posted: 9 May 2016 Last revised: 5 Aug 2016

Date Written: July 7, 2016

Abstract

I empirically examine the system-wide volatility connectedness risk of currencies as an explanation for the risk premium of carry trade returns. Carry trade strategies exploit the forward premium puzzle by borrowing in low interest rate currencies and investing in high interest currencies without losing the generated gain to a corresponding change in exchange rates. I find that system-wide volatility connectedness risk carries a significant and negative risk premium. That is, low interest rate currencies are positively related to system-wide volatility connectedness risk, while high interest rate currencies display a negative correlation. Low interest rate currencies thus serve as a hedge during unexpectedly high system-wide volatility connectedness episodes, indicating bad states of the world. In contrast, high interest rate currencies perform particularly poorly during these periods.

Keywords: system-wide volatility connectedness, carry trade, international finance

JEL Classification: F31, G12, G15

Suggested Citation

Gisler, Katja, System-Wide Volatility Connectedness and Carry Trades (July 7, 2016). Available at SSRN: https://ssrn.com/abstract=2777041 or http://dx.doi.org/10.2139/ssrn.2777041

Katja Gisler (Contact Author)

University of St. Gallen ( email )

Institute of Mathematics and Statistics
Bodanstrasse 6
St. Gallen, St. Gallen CH-9000
Switzerland

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