Carry and Trend Following Returns in the Foreign Exchange Market
Peter Smith () and
Discussion Papers from Department of Economics, University of York
Recent research has confirmed the behaviour of traders that significant excess returns can be achieved from following the predictions of the carry trade which involves buying currencies with relatively high short-term interest rates, or equivalently a high forward premium, and selling those with relatively low interest rates. This paper shows that similar-sized excess returns can be achieved by following a trend-following strategy which buys long positions in currencies that have achieved positive returns and otherwise holds cash. We demonstrate that market risk is an important determinant of carry returns but that the standard unconditional CAPM is inadequate in explaining the cross-section of forward premium ordered portfolio returns. We also show that the downside risk CAPM fails to explain this cross-section, in contrast to recent literature. A conditional CAPM which makes the impact of the market return as a risk factor depend on a measure of market liquidity performs very well in explaining more than 90% of the variation in portfolio returns and more than 90% of the average returns to the carry trade. Trend following is found to provide a significant hedge against these risks. The performance of the trend following factor is more surprising given that it does not have the negative skewness or maximum drawdown characteristic which is shown by the carry trade factor.
Keywords: Forward exchange rate returns; trend following; carry trade; market liquidity and exchange risk (search for similar items in EconPapers)
JEL-codes: F31 G12 G11 G15 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-fmk, nep-ifn and nep-opm
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