Carry Trades and Global FX Volatility

Lukas Menkhoff (), Lucio Sarno (), Maik Schmeling and Andreas Schrimpf

MPRA Paper from University Library of Munich, Germany

Abstract: We investigate the relation between global FX volatility and the excess returns to carry trade portfolios. We find a significantly negative return co-movement of high interest rate currencies with global volatility, whereas low interest rate currencies provide a hedge against volatility shocks. Our main global FX volatility proxy accounts for more than 90% of the return spread in five carry trade portfolios. Further analyses show that: (i) liquidity risk also matters for excess returns, but to a lesser degree; and that (ii) excess returns are more strongly related to unexpected components of volatility than to expected components. Our results are robust to different proxies for volatility risk, and extend to other cross-sections such as individual currency returns and (some) momentum portfolios.

Keywords: Carry Trade; Volatility; Liquidity; Forward Premium Puzzle (search for similar items in EconPapers)
JEL-codes: G12 G15 F31 (search for similar items in EconPapers)
Date: 2009-04-07
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