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The Time-Varying Systematic Risk of Carry Trade Strategies

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  • Christiansen, Charlotte
  • Ranaldo, Angelo
  • Söderlind, Paul

Abstract

We explain the currency carry trade performance using an asset pricing model in which factor loadings are regime-dependent rather than constant. Empirical results show that a typical carry trade strategy has much higher exposure to the stock market and is mean-reverting in regimes of high FX volatility. The findings are robust to various extensions, including more currencies, longer samples, transaction costs, international stock indices, and other proxies for volatility and liquidity. Our regime-dependent pricing model provides significantly smaller pricing errors than a traditional model. Thus, the carry trade performance is better explained by its time-varying systematic risk that magnifies in volatile markets-suggesting a partial explanation for the Uncovered Interest Rate Parity puzzle.

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Bibliographic Info

Article provided by Cambridge University Press in its journal Journal of Financial and Quantitative Analysis.

Volume (Year): 46 (2011)
Issue (Month): 04 (September)
Pages: 1107-1125

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Handle: RePEc:cup:jfinqa:v:46:y:2011:i:04:p:1107-1125_00

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References

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Citations

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Cited by:
  1. Mathias Hoffmann & Rahel Suter, 2013. "Systematic Consumption Risk in Currency Returns," CESifo Working Paper Series 4273, CESifo Group Munich.
  2. Mathias Hoffmann & Rahel Suter, 2013. "Systematic consumption risk in currency returns," ECON - Working Papers 124, Department of Economics - University of Zurich.
  3. Victoria Galsband & Thomas Nitschka, 2013. "Currency excess returns and global downside market risk," Working Papers 2013-07, Swiss National Bank.
  4. Nektarios Aslanidis & Charlotte Christiansen, 2010. "Smooth Transition Patterns in the Realized Stock Bond Correlation," CREATES Research Papers 2010-15, School of Economics and Management, University of Aarhus.
  5. Doukas, John A. & Zhang, Hao, 2013. "The performance of NDF carry trades," Journal of International Money and Finance, Elsevier, vol. 36(C), pages 172-190.
  6. Bakshi, Gurdip & Panayotov, George, 2013. "Predictability of currency carry trades and asset pricing implications," Journal of Financial Economics, Elsevier, vol. 110(1), pages 139-163.
  7. Habib, Maurizio M. & Stracca, Livio, 2012. "Getting beyond carry trade: What makes a safe haven currency?," Journal of International Economics, Elsevier, vol. 87(1), pages 50-64.
  8. Aslanidis, Nektarios & Casas, Isabel, 2013. "Nonparametric correlation models for portfolio allocation," Journal of Banking & Finance, Elsevier, vol. 37(7), pages 2268-2283.
  9. Ülkü, Numan & Karpova, Yekaterina, 2014. "Do international equity investors rebalance to manage currency exposure? A study of Greece foreign investor flows data," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 29(C), pages 150-169.
  10. Hanno Lustig & Adrien Verdelhan, 2008. "The Cross-Section of Foreign Currency Risk Premia and Consumption Growth Risk: A Reply," NBER Working Papers 13812, National Bureau of Economic Research, Inc.
  11. Vistesen, Claus, 2008. "Of Low Yielders and Carry Trading – the JPY and CHF as Market Risk Sentiment Gauges," MPRA Paper 9952, University Library of Munich, Germany.
  12. Charlotte Christiansen & Maik Schmeling & Andreas Schrimpf, 2012. "A Comprehensive Look at Financial Volatility Prediction by Economic Variables," BIS Working Papers 374, Bank for International Settlements.
  13. Adrien Verdelhan, 2012. "The Share of Systematic Variation in Bilateral Exchange Rates," 2012 Meeting Papers 763, Society for Economic Dynamics.
  14. Erik Schlogl & Yang Chang, 2012. "Carry Trade and Liquidity Risk: Evidence from Forward and Cross-Currency Swap Markets," Research Paper Series 310, Quantitative Finance Research Centre, University of Technology, Sydney.
  15. Jacob Gyntelberg & Andreas Schrimpf, 2011. "FX strategies in periods of distress," BIS Quarterly Review, Bank for International Settlements, December.
  16. Lee, Hsiu-Chuan & Chang, Shu-Lien, 2013. "Spillovers of currency carry trade returns, market risk sentiment, and U.S. market returns," The North American Journal of Economics and Finance, Elsevier, vol. 26(C), pages 197-216.
  17. Aslanidis, Nektarios & Christiansen, Charlotte, 2011. "Quantiles of the Realized Stock-Bond Correlation," Working Papers 2072/151809, Universitat Rovira i Virgili, Department of Economics.
  18. Christian Grisse & Thomas Nitschka, 2013. "On financial risk and the safe haven characteristics of Swiss franc exchange rates," Working Papers 2013-04, Swiss National Bank.
  19. Karnaukh, Nina & Ranaldo, Angelo & Söderlind, Paul, 2013. "Understanding FX Liquidity," Working Papers on Finance 1315, University of St. Gallen, School of Finance.

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