The Revenge of Purchasing Power Parity on Carry Trades during Crises

Marie Brière () and Bastien Drut ()

No 09-013.RS, Working Papers CEB from Université Libre de Bruxelles, Solvay Brussels School of Economics and Management, Centre Emile Bernheim (CEB)

Abstract: Empirical evidence shows that fundamental models have produced disappointing results over the past 20 years while carry trade strategies have performed superbly. But the real picture is much more complex. In fact, the track records of both strategies have varied considerably. This article shows that they have actually alternated between periods of profitability and underperformance. It also shows that when carry trade strategies perform well, fundamental strategies do poorly, and vice versa. Crises appear to play a significant role in the alternation of investment styles on currency markets. In contrast to carry trades, fundamental strategies perform remarkably well in crises. A portfolio that rotates between these two types of strategies, based on a risk aversion indicator such as implied equity volatility, would substantially outperform a pure carry trade strategy and would be robust to crises.

Keywords: carry trades; exchange rates; financial crisis; risk aversion; investment strategy; purchasing power parity; fundamentals model. (search for similar items in EconPapers)
JEL-codes: F31 G15 G11 G01 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba and nep-ifn
Date: 2009-03
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http://www.solvay.edu/EN/Research/Bernheim/documents/wp09013.pdf First version, 2009 (application/pdf)

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Persistent link: http://EconPapers.repec.org/RePEc:sol:wpaper:09-013

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