Long-Run Interest Rate Differentials and the Profitability of Currency Carry

Mohammed Mehdi Kaebi () and Igor Ferreira Batista Martins ()
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Mohammed Mehdi Kaebi: Insper - Instituto de Ensino e Pesquisa, Postal: Insper, Rua Quat´a, 300, Sao Paulo, Brazil, https://bv.fapesp.br/en/pesquisador/731957/mohammed-mehdi-kaebi/
Igor Ferreira Batista Martins: Örebro University School of Business, Postal: Örebro University, School of Business, SE - 701 82 ÖREBRO, Sweden, https://www.oru.se/english/employee/igor_ferreira-batista-martins

No 2025:10, Working Papers from Örebro University, School of Business

Abstract: This paper examines the role of long-run and cyclical components of interest rate differentials in explaining the returns to currency carry strategies. We show that long-run differentials account for most of the profitability, while cyclical differentials play only a limited role. A simple strategy that goes long currencies above the median long-run differential and shorts those below delivers a statistically and economically significant annualized excess return of 2.48%. Relative to traditional carry, our strategy achieves a higher Sharpe ratio, lower turnover and a less negative skewness. We introduce a new tradable carry factor that explains the cross section of currency returns beyond the benchmark carry factor.

Keywords: Carry trade; currencies; long-run interest rates; trend-cycle decomposition. (search for similar items in EconPapers)
JEL-codes: F31 G12 G15 (search for similar items in EconPapers)
Pages: 18 pages
Date: 2025-09-26
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Persistent link: https://EconPapers.repec.org/RePEc:hhs:oruesi:2025_010

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