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Currency Carry Trade Regimes: Beyond the Fama Regression

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  • Richard Clarida
  • Josh Davis
  • Niels Pedersen

Abstract

We examine the factors that account for the returns on currency carry trade strategies. Using a dataset of daily returns spanning 18 years for 5 different long - short currency carry portfolios, we first document a robust empirical relationship between carry trade excess returns and exchange rate volatility, both realized and implied. Specifically, we extend and refine the results in Bhansali (2007) by documenting that currency carry trade strategies implemented with forward contracts have payoff and risk characteristics that are similar to those of currency option strategies that sell out of the money puts on high interest rates currencies. Both strategies have the feature of collecting premiums or carry to generate persistent excess returns that unwind sharply resulting in losses when actual and implied volatility rise. We next also document significant volatility regime sensitivity for Fama regressions estimated over low and high volatility periods. Specifically we find that the well known result that a regression of the realized exchange rate depreciation on the lagged interest rate differential produces a negative slope coefficient (instead of unity as predicted by uncovered interest parity) is an artifact of the volatility regime: when volatility is in the top quartile, the Fama regression produces a positive coefficient that is greater than unity. The third section of the paper documents the existence of an intuitive and significant co-movement between currency risk premium and risk premia in yield curve factors that drive bond yields in the countries that comprise carry trade pairs. We show that yield curve level factors are positively correlated with carry trade excess returns while yield curve slope factors are negatively correlated with carry trade excess returns. Importantly, we show that this correlation is robust to the current crisis and to the inclusion of equity volatility in the model. What distinguishes carry trade returns in the current crisis from non crisis periods is not changed loading on yield curve factors but a much larger loading on the equity factor.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 15523.

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Date of creation: Nov 2009
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Publication status: published as Clarida, Richard & Davis, Josh & Pedersen, Niels, 2009. "Currency carry trade regimes: Beyond the Fama regression," Journal of International Money and Finance, Elsevier, vol. 28(8), pages 1375-1389, December.
Handle: RePEc:nbr:nberwo:15523

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  1. Geert Bekaert, 2001. "Expectations Hypotheses Tests," Journal of Finance, American Finance Association, American Finance Association, vol. 56(4), pages 1357-1394, 08.
  2. Clarida, Richard H. & Sarno, Lucio & Taylor, Mark P. & Valente, Giorgio, 2003. "The out-of-sample success of term structure models as exchange rate predictors: a step beyond," Journal of International Economics, Elsevier, Elsevier, vol. 60(1), pages 61-83, May.
  3. David K. Backus, 2001. "Affine Term Structure Models and the Forward Premium Anomaly," Journal of Finance, American Finance Association, American Finance Association, vol. 56(1), pages 279-304, 02.
  4. Markus K. Brunnermeier & Stefan Nagel & Lasse H. Pedersen, 2009. "Carry Trades and Currency Crashes," NBER Chapters, in: NBER Macroeconomics Annual 2008, Volume 23, pages 313-347 National Bureau of Economic Research, Inc.
  5. David Backus & Silverio Foresi & Chris Telmer, 1996. "Affine Models of Currency Pricing," New York University, Leonard N. Stern School Finance Department Working Paper Seires, New York University, Leonard N. Stern School of Business- 96-9, New York University, Leonard N. Stern School of Business-.
  6. Richard H. Clarida & Daniel Waldman, 2008. "Is Bad News About Inflation Good News for the Exchange Rate? And, If So, Can That Tell Us Anything about the Conduct of Monetary Policy?," NBER Chapters, in: Asset Prices and Monetary Policy, pages 371-396 National Bureau of Economic Research, Inc.
  7. Richard Clarida & Jordi Gali & Mark Gertler, 2002. "A Simple Framework for International Monetary Policy Analysis," NBER Working Papers 8870, National Bureau of Economic Research, Inc.
  8. Fama, Eugene F., 1984. "Forward and spot exchange rates," Journal of Monetary Economics, Elsevier, Elsevier, vol. 14(3), pages 319-338, November.
  9. Hansen, Lars Peter & Hodrick, Robert J, 1980. "Forward Exchange Rates as Optimal Predictors of Future Spot Rates: An Econometric Analysis," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 88(5), pages 829-53, October.
  10. Engel, Charles, 1996. "The forward discount anomaly and the risk premium: A survey of recent evidence," Journal of Empirical Finance, Elsevier, Elsevier, vol. 3(2), pages 123-192, June.
  11. Craig Burnside & Martin Eichenbaum & Isaac Kleshchelski & Sergio Rebelo, 2006. "The Returns to Currency Speculation," 2006 Meeting Papers, Society for Economic Dynamics 864, Society for Economic Dynamics.
  12. Ichiue, Hibiki & Koyama, Kentaro, 2011. "Regime switches in exchange rate volatility and uncovered interest parity," Journal of International Money and Finance, Elsevier, Elsevier, vol. 30(7), pages 1436-1450.
  13. Meese, Richard A. & Rogoff, Kenneth, 1983. "Empirical exchange rate models of the seventies : Do they fit out of sample?," Journal of International Economics, Elsevier, Elsevier, vol. 14(1-2), pages 3-24, February.
  14. Nelson, Daniel B, 1991. "Conditional Heteroskedasticity in Asset Returns: A New Approach," Econometrica, Econometric Society, Econometric Society, vol. 59(2), pages 347-70, March.
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