Carry Trades and Global Foreign Exchange Volatility

Lukas Menkhoff, Lucio Sarno, Andreas Schrimpf and Maik Schmeling

No 8291, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: We investigate the relation between global foreign exchange (FX) volatility risk and the cross-section of excess returns arising from popular strategies that borrow in low interest rate currencies and invest in high-interest rate currencies, so-called 'carry trades'. We find that high interest rate currencies are negatively related to innovations in global FX volatility and thus deliver low returns in times of unexpected high volatility, when low interest rate currencies provide a hedge by yielding positive returns. Our proxy for global FX volatility risk captures more than 90% of the cross-sectional excess returns in five carry trade portfolios. In turn, these results provide evidence that there is an economically meaningful risk-return relation in the FX market. Further analysis shows that liquidity risk also matters for expected FX returns, but to a lesser degree than volatility risk. Finally, exposure to our volatility risk proxy also performs well for pricing returns of other cross sections in foreign exchange, U.S. equity, and corporate bond markets.

Keywords: Carry trade; Forward premium puzzle; Liquidity; Volatility (search for similar items in EconPapers)
JEL-codes: F31 G12 G15 (search for similar items in EconPapers)
Date: 2011-03
New Economics Papers: this item is included in nep-ifn, nep-mst and nep-opm
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Citations: View citations in EconPapers (27)

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Journal Article: Carry Trades and Global Foreign Exchange Volatility (2012)
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