Carry Trade Strategies with Factor Augmented Macro Fundamentals: A Dynamic Markov-Switching Factor Model
The International Journal of Business and Finance Research, v. 10 (3) p. 11-28
18 Pages Posted: 23 Feb 2017
Date Written: 2016
This paper evaluates the performance of carry trade strategies with macro fundamentals in a Markov switching dynamic factor augmented regression framework and compares the performance statistics with the benchmark model of a random walk and momentum strategy. I make simulations with the Japanese Yen, Swiss Franc and US Dollar as funding currencies against six target currencies. Carry trade, a currency speculation strategy between the high-interest rate and low-interest rate currencies, generates high payoffs on average but has a possibility of crash risk. I argue that risk adjusted returns, mean returns and downside risk perform better when purchasing power parity model is used in a both regime switching and linear factor augmented regression framework for Franc trades and perform as good as benchmark model of momentum strategy for Dollar and Yen trades.
Keywords: Exchange Rate Models, Carry Trade, Forecasting, Markov-Switching Dynamic Factor
JEL Classification: C22, E32, E37, E43, F31, F37, G15
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