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The Carry Trade and Fundamentals: Nothing to Fear But FEER Itself

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  • Òscar Jordà
  • Alan M. Taylor

Abstract

The carry trade is the investment strategy of going long in high-yield target currencies and short in low-yield funding currencies. Recently, this naive trade has seen very high returns for long periods, followed by large crash losses after large depreciations of the target currencies. Based on low Sharpe ratios and negative skew, these trades could appear unattractive, even when diversified across many currencies. But more sophisticated conditional trading strategies exhibit more favorable payoffs. We apply novel (within economics) binary-outcome classification tests to show that our directional trading forecasts are informative, and out-of-sample loss-function analysis to examine trading performance. The critical conditioning variable, we argue, is the fundamental equilibrium exchange rate (FEER). Expected returns are lower, all else equal, when the target currency is overvalued. Like traders, researchers should incorporate this information when evaluating trading strategies. When we do so, some questions are resolved: negative skewness is purged, and market volatility (VIX) is uncorrelated with returns; other puzzles remain: the more sophisticated strategy has a very high Sharpe ratio, suggesting market inefficiency.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 15518.

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Date of creation: Nov 2009
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Publication status: published as Jordà , Òscar & Taylor, Alan M., 2012. "The carry trade and fundamentals: Nothing to fear but FEER itself," Journal of International Economics, Elsevier, vol. 88(1), pages 74-90.
Handle: RePEc:nbr:nberwo:15518

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Cited by:
  1. Charles Engel, 2013. "Exchange Rates and Interest Parity," NBER Working Papers 19336, National Bureau of Economic Research, Inc.
  2. Reinout De Bock & Irineu E. Carvalho Filho, 2013. "The Behavior of Currencies during Risk-off Episodes," IMF Working Papers 13/8, International Monetary Fund.
  3. Engel, Charles, 2011. "The Real Exchange Rate, Real Interest Rates, and the Risk Premium," Economics Series 265, Institute for Advanced Studies.
  4. Mathias Hoffmann & Rahel Suter, 2013. "Systematic consumption risk in currency returns," ECON - Working Papers 124, Department of Economics - University of Zurich.
  5. Habib, Maurizio Michael & Stracca, Livio, 2011. "Getting beyond carry trade: what makes a safe haven currency?," Working Paper Series 1288, European Central Bank.
  6. Cho, Dooyeon & Doblas-Madrid, Antonio, 2014. "Trade intensity and purchasing power parity," Journal of International Economics, Elsevier, vol. 93(1), pages 194-209.
  7. Christopher J. Neely & Paul A. Weller, 2011. "Lessons from the evolution of foreign exchange trading strategies," Working Papers 2011-021, Federal Reserve Bank of St. Louis.
  8. Ding, Liang & Ma, Jun, 2013. "Portfolio reallocation and exchange rate dynamics," Journal of Banking & Finance, Elsevier, vol. 37(8), pages 3100-3124.
  9. Tarek A. Hassan & Rui C. Mano, 2014. "Forward and Spot Exchange Rates in a Multi-currency World," NBER Working Papers 20294, National Bureau of Economic Research, Inc.
  10. Ian Martin, 2011. "The Forward Premium Puzzle in a Two-Country World," NBER Working Papers 17564, National Bureau of Economic Research, Inc.
  11. Malliaris, A.G. & Malliaris, Mary, 2011. "Are foreign currency markets interdependent? evidence from data mining technologies," MPRA Paper 35261, University Library of Munich, Germany.
  12. Huang, Huichou & MacDonald, Ronald & Zhao, Yang, 2012. "Global Currency Misalignments, Crash Sensitivity, and Downside Insurance Costs," MPRA Paper 53745, University Library of Munich, Germany, revised 18 Nov 2013.
  13. Travis J. Berge & Òscar Jordà, 2011. "Evaluating the Classification of Economic Activity into Recessions and Expansions," American Economic Journal: Macroeconomics, American Economic Association, vol. 3(2), pages 246-77, April.
  14. Snaith, Stuart & Coakley, Jerry & Kellard, Neil, 2013. "Does the forward premium puzzle disappear over the horizon?," Journal of Banking & Finance, Elsevier, vol. 37(9), pages 3681-3693.
  15. Dick, Christian D. & MacDonald, Ronald & Menkhoff, Lukas, 2011. "Individual exchange rate forecasts and expected fundamentals," ZEW Discussion Papers 11-062, ZEW - Zentrum für Europäische Wirtschaftsforschung / Center for European Economic Research.

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