Currency Carry Trades and the Conditional Factor Model

Abstract

This study employs a conditional factor model in order to investigate the time-varying profitability of currency carry trades. To that end, I estimate conditional alphas and betas on the popular dollar and carry factors through the use of a nonparametric approach. The empirical results illustrate that the alphas and betas vary over time. Furthermore, I find that the alpha of a high interest rate currency portfolio increases in a trough in a business cycle and in a state of high market uncertainty. However, the beta on the dollar factor decreases in these market conditions, suggesting that investors reduce the foreign currency risk exposure.

Keywords: Currency Carry Trades, Conditional Factor Model, Nonparametric Estimator, Time-Varying Beta

JEL Classification: C14, C58, F31