System-Wide Volatility Connectedness and Carry Trades
53 Pages Posted: 9 May 2016 Last revised: 5 Aug 2016
Date Written: July 7, 2016
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: Suggested Citation