The Rise and Fall of the Carry Trade: Links to Exchange Rate Predictability

52 Pages Posted: 27 Sep 2019

See all articles by Ilias Filippou

Ilias Filippou

Washington University in St. Louis - John M. Olin Business School

David Rapach

Saint Louis University; Washington University in St. Louis

Mark P. Taylor

Washington University in St. Louis - John M. Olin Business School; Centre for Economic Policy Research (CEPR)

Guofu Zhou

Washington University in St. Louis - John M. Olin Business School; China Academy of Financial Research (CAFR)

Date Written: September 17, 2019

Abstract

We investigate out-of-sample exchange rate predictability in a high-dimensional panel predictive regression model that includes numerous country characteristics and their interactions with a variety of global variables. To avoid the overfitting problem that plagues conventional estimation of high-dimensional models, we estimate the panel predictive regression model via the elastic net, a machine learning technique based on penalized regression. The elastic net forecasts significantly outperform the no-change benchmark forecast that has proven difficult to beat in the literature. Out-of-sample exchange rate predictability becomes considerably stronger starting in the fall of 2008 during the worst stage of the global financial crisis. We show that exchange rate predictability can substantially improve the performance of conventional carry trade strategies: a smart carry portfolio that incorporates the information in the elastic net forecasts avoids the crash experienced by a conventional carry portfolio in late 2008 and markedly improves portfolio performance thereafter.

Keywords: Carry, Currency excess return, Panel predictive regression, Machine learning, Penalized regression, Short-horizon predictability, Global financial crisis

JEL Classification: F31, G11, G12, G15

Suggested Citation

Filippou, Ilias and Rapach, David and Taylor, Mark Peter and Zhou, Guofu, The Rise and Fall of the Carry Trade: Links to Exchange Rate Predictability (September 17, 2019). Available at SSRN: https://ssrn.com/abstract=3455713 or http://dx.doi.org/10.2139/ssrn.3455713

Ilias Filippou

Washington University in St. Louis - John M. Olin Business School ( email )

One Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States

David Rapach (Contact Author)

Saint Louis University ( email )

3674 Lindell Blvd
St. Louis, MO 63108-3397
United States

HOME PAGE: http://https://sites.google.com/slu.edu/daverapach

Washington University in St. Louis

One Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States

HOME PAGE: http://https://sites.google.com/slu.edu/daverapach

Mark Peter Taylor

Washington University in St. Louis - John M. Olin Business School ( email )

One Brookings Drive
Campus Box 1156
St. Louis, MO 63130-4899
United States

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Guofu Zhou

Washington University in St. Louis - John M. Olin Business School ( email )

Washington University
Campus Box 1133
St. Louis, MO 63130-4899
United States
314-935-6384 (Phone)
314-658-6359 (Fax)

HOME PAGE: http://apps.olin.wustl.edu/faculty/zhou/

China Academy of Financial Research (CAFR)

Shanghai Advanced Institute of Finance
Shanghai P.R.China, 200030
China

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