Modelling and explaining carry trade excess returns in the foreign exchange market

Abstract

The goal of this paper is to obtain a thorough understanding of the foreign exchange market and the pricing process of exchange rates. The main focus is on the most popular currency trading strategy, carry trade, which is defined as borrowing low-yielding currencies and investing in high-yielding currencies. If Uncovered Interest Rate Parity (UIP) held, carry trade should not be profitable because exchange rate change should eliminate any gain arising from interest rate differential. Hence, carry trade speculates against UIP. Most empirical evidence, including my own initial analysis, agrees that most of the time the offset is not complete and sometimes the exchange rate even moves to the opposite way, i.e. carry trade target currency appreciates against the funding currency. As carry trade clearly turns out to be a profitable trading strategy, this paper aims to identify proper explanations for this so called forward premium puzzle. In order to do so different risk concepts and market anomalies are discussed extensively.

The main contribution of this paper is to emphasize the role of risk-aversion in determining the carry trade returns. Indeed, there is strong evidence that carry trade gains in normal times when risk-aversion is low and loses in times of turbulence. Based on the data of daily exchange rates and interest rates of G10 countries in 1997–2012, I report convincing evidence of nonlinearity in the UIP relationship that becomes completely visible by utilizing Smooth Transition Regression -model, which allows different exchange rate behaviour between two regimes, e.g. expansions and recessions. This modelling framework fits excellently the theoretical background that emphasizes the role of risk-aversion in asset pricing. The final part of the paper shows how the risk-aversion indicators can be exploited in a trading strategy. By using TED spread, credit spread, and/or VIX as a trading signal it was possible to improve dramatically the performance of carry trade portfolio.