22 Pages Posted: 25 May 2018
Date Written: May 11, 2018
The carry trade in foreign currencies is known for delivering positive returns on average, and for occasionally suffering large losses. While these characteristics prevail on average across time and across currency pairs, we find that interest rate differentials on their own are not sufficient to identify conditions in which currencies exhibit these return and risk attributes reliably. We use three variables – valuation, volatility and crowding – to identify time periods and cross-sections of currencies in which the carry trade performs best. We document a substantial difference in performance between the carry trade applied to high-volatility versus low-volatility currency pairs. In the full sample from 1984 to 2017, carry in high-volatility pairs has consisted of currencies which are undervalued on average, experience greater swings in valuation, and have boom and bust cycles aligned with investor crowding. This finding is consistent with the notion that carry represents a risk premium. Carry in low-volatility pairs has the opposite characteristics. Though both strategies performed well prior to the 2008 financial crisis, only carry in high-volatility pairs has worked since.
Keywords: Carry Trade, Currencies, Centrality, Crowded Trades, Forward Premium, Valuations, Turbulence
JEL Classification: C60, C61, F31, G10, G11, G15
Suggested Citation: Suggested Citation