Cutting the Gordian Knot of Carry and Imbalances

49 Pages Posted: 27 Aug 2018 Last revised: 8 Jun 2021

See all articles by Pedro Barroso

Pedro Barroso

CATÓLICA-LISBON School of Business & Economics

Frickson Kho

UNSW Business School

Florent Rouxelin

University of New South Wales (UNSW)

Li Yang

UNSW Australia Business School, School of Banking and Finance; Financial Research Network (FIRN)

Date Written: August 15, 2018

Abstract

Countries' external imbalances or interest rates produce similar currency sorts on average. Disentangling the two signals, we find that carry risk premiums come entirely from interest rates. An alternative carry formed on interest rates orthogonal to external imbalances increases the Sharpe ratio by 38% and is not spanned by traditional carry or imbalance factors. Strikingly, this new orthogonal carry subsumes traditional carry. Traditional carry has well-known exposure to stock market returns and performs badly when FX volatility is high. We find these stylized facts are entirely driven by its association with imbalances factors which have similar risk attributes while orthogonal carry does not.

Keywords: Carry trades; Global imbalances; Net foreign assets; Currency risk premiums.

JEL Classification: F31, F37, G12, G15

Suggested Citation

Barroso, Pedro and Kho, Frickson and Rouxelin, Florent and Yang, Li, Cutting the Gordian Knot of Carry and Imbalances (August 15, 2018). Available at SSRN: https://ssrn.com/abstract=3232396 or http://dx.doi.org/10.2139/ssrn.3232396

Pedro Barroso (Contact Author)

CATÓLICA-LISBON School of Business & Economics ( email )

Palma de Cima
Lisbon, Lisboa 1649-023
Portugal

HOME PAGE: http://https://clsbe.lisboa.ucp.pt/person/pedro-monteiro-e-silva-barroso

Frickson Kho

UNSW Business School

UNSW Business School
High St
Sydney, NSW 2052
Australia

Florent Rouxelin

University of New South Wales (UNSW) ( email )

Kensington
High St
Sydney, NSW 2052
Australia

Li Yang

UNSW Australia Business School, School of Banking and Finance ( email )

Sydney, NSW 2052
Australia
+610293855857 (Phone)

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

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