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Foreign exchange risk and the predictability of carry trade returns

Cenedese, G., Sarno, L. and Tsiakas, I. (2014). Foreign exchange risk and the predictability of carry trade returns. Journal of Banking & Finance, 42, pp. 302-313. doi: 10.1016/j.jbankfin.2014.01.040

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.

Publication Type: Article
Additional Information: © 2014, Elsevier. Licensed under the Creative Commons Attribution-NonCommercial-NoDerivatives 4.0 International http://creativecommons.org/licenses/by-nc-nd/4.0/
Publisher Keywords: Exchange rates; Carry trade; Market variance; Average variance; Average correlation; Quantile regression
Subjects: H Social Sciences > HG Finance
Departments: Cass Business School > Finance
URI: http://openaccess.city.ac.uk/id/eprint/13159
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