The Forward Premium Bias, Carry Trade Return and the Risks of Volatility and Liquidity
60 Pages Posted: 4 Jun 2016
Date Written: May 2016
In this paper, we analyse the relationship between the currency carry return and volatility and liquidity risk factors. We find that both categories of risk factors are relevant to understanding and explaining carry return, with an outperformance for volatility ones especially the global FX volatility risk factor. Consistent with the poor performance of currency carry trades during high FX volatility regime, we also show that the well-established negative slope coefficient in the Fama regression tends to be more positive and even above unity in times of high FX volatility. The paper, overall, contributes to the risk-based solution of the forward premium bias puzzle.
Keywords: FX rates, Currency carry trade, Forward-bias puzzle, FX risk premium
JEL Classification: F31, F41, G11, G15, E44
Suggested Citation: Suggested Citation