On the predictability of carry trade returns: The case of the Chinese Yuan

The Chinese Yuan or Renminbi has not been given due attention in the literature despite its importance in providing stability in global FX markets and attaining IMF reserve currency status. Unlike other currencies, the Yuan is subject to strict monetary controls by the People’s Bank of China. We explore factors that explain Yuan carry trade returns during the dollar-peg and managed float regimes by observing its response to the dollar risk factor, global FX volatility innovations and, liquidity. Using the traditional Fama and Macbeth (1973) two-pass ordinary least squares regression, we find that the effects of the dollar risk factor, global FX volatility innovations and liquidity on Yuan carry trade returns: (1) are unlike those on other currencies; (2) vary monotonically as the maturity of the carry trade position increases; and (3) are affected by the exchange rate regime in force. Our results suggest that short-term Yuan carry trade portfolios may serve as a hedge against market volatility. 1-year positions are far more resilient and deliver substantial returns especially during periods of low market volatility. Our results also exhibit the Yuan’s dependence on the dollar in its valuation besides the transfer of wealth between U.S. equity markets and dollar-denominated assets to the Yuan and Yuan-denominated assets.