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Foreign Exchange Risk and the Predictability of Carry Trade Returns

Author

Listed:
  • Gino Cenedese

    (Bank of England, UK)

  • Lucio Sarno

    (City University London, UK; CEPR, UK)

  • Ilias Tsiakas

    (University of Guelph, Canada)

Abstract
This paper provides an empirical investigation of the time-series predictive ability of foreign exchange risk measures on the return to the carry trade, a popular investment strategy that borrows in low-interest currencies and lends in high-interest currencies. Using quantile regressions, we find that higher market variance is significantly related to large future carry trade losses, which is consistent with the unwinding of the carry trade in times of high volatility. The decomposition of market variance into average variance and average correlation shows that the predictive power of market variance is primarily due to average variance since average correlation is not significantly related to carry trade returns. Finally, a new version of the carry trade that conditions on market variance generates performance gains net of transaction costs.

Suggested Citation

  • Gino Cenedese & Lucio Sarno & Ilias Tsiakas, 2014. "Foreign Exchange Risk and the Predictability of Carry Trade Returns," Working Paper series 02_14, Rimini Centre for Economic Analysis.
    • Handle: RePEc:rim:rimwps:02_14
    as

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    References listed on IDEAS

    as
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    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    Exchange Rates; Carry Trade; Market Variance; Average Variance; Average Correlation; Quantile Regression;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation

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