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The Time-Varying Systematic Risk of Carry Trade Strategies

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  • Charlotte Christiansen
  • Angelo Ranaldo
  • Paul Söderlind

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

Paper provided by Swiss National Bank in its series Working Papers with number 2010-01.

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Length: 42 pages
Date of creation: 2010
Date of revision:
Handle: RePEc:snb:snbwpa:2010-01

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Keywords: carry trade; factor model; FX volatility; liquidity; smooth transition regression; time-varying betas;

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References

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