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The Revenge of Purchasing Power Parity on Carry Trades during Crises

  • Drut, Bastien
  • Brière, Marie

Empirical evidence shows that fundamental models have produced disappointing results over the past 20 years while carry trade strategies have performed superbly. But the real picture is much more complex. In fact, the track records of both strategies have varied considerably. This article shows that they have actually alternated between periods of profitability and underperformance. It also shows that when carry trade strategies perform well, fundamental strategies do poorly, and vice versa. Crises appear to play a significant role in the alternation of investment styles on currency markets. In contrast to carry trades, fundamental strategies perform remarkably well in crises. A portfolio that rotates between these two types of strategies, based on a risk aversion indicator such as implied equity volatility, would substantially outperform a pure carry trade strategy and would be robust to crises.

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File URL: http://basepub.dauphine.fr/xmlui/bitstream/123456789/7743/1/RePEc_sol_wpaper_09-013.pdf
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Paper provided by Paris Dauphine University in its series Economics Papers from University Paris Dauphine with number 123456789/7743.

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Date of creation: Jul 2009
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Publication status: Published in CEB Working Paper, 2009
Handle: RePEc:dau:papers:123456789/7743
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  1. Marie Briere & Ariane Szafarz, 2007. "Crisis-Robust Bond Portfolios," Working Papers CEB 07-030.RS, ULB -- Universite Libre de Bruxelles.
  2. 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.
  3. Gabriele Galati & Alexandra Heath & Patrick McGuire, 2007. "Evidence of carry trade activity," BIS Quarterly Review, Bank for International Settlements, September.
  4. Andrew Ang & Geert Bekaert, 2002. "International Asset Allocation With Regime Shifts," Review of Financial Studies, Society for Financial Studies, vol. 15(4), pages 1137-1187.
  5. Pierre Collin-Dufresne, 2001. "The Determinants of Credit Spread Changes," Journal of Finance, American Finance Association, vol. 56(6), pages 2177-2207, December.
  6. Meese, Richard A. & Rogoff, Kenneth, 1983. "Empirical exchange rate models of the seventies : Do they fit out of sample?," Journal of International Economics, Elsevier, vol. 14(1-2), pages 3-24, February.
  7. Yin-Wong Cheung & Menzie D. Chinn & Antonio Garcia Pascual, 2002. "Empirical Exchange Rate Models of the Nineties: Are Any Fit to Survive?," NBER Working Papers 9393, National Bureau of Economic Research, Inc.
  8. Gabriele Galati & Michael Melvin, 2004. "Why has FX trading surged?," BIS Quarterly Review, Bank for International Settlements, December.
  9. Marie Briere & Alexandre Burgues & Ombretta Signori, 2008. "Volatility Exposure for Strategic Asset Allocation," Working Papers CEB 08-034.RS, ULB -- Universite Libre de Bruxelles.
  10. Joseph E. Gagnon & Alain P. Chaboud, 2007. "What can the data tell us about carry trades in Japanese yen?," International Finance Discussion Papers 899, Board of Governors of the Federal Reserve System (U.S.).
  11. Jun Pan & Kenneth J. Singleton, 2008. "Default and Recovery Implicit in the Term Structure of Sovereign "CDS" Spreads," Journal of Finance, American Finance Association, vol. 63(5), pages 2345-2384, October.
  12. John Cairns & Corrinne Ho & Robert McCauley, 2007. "Exchange rates and global volatility: implications for Asia-Pacific currencies," BIS Quarterly Review, Bank for International Settlements, March.
  13. Jacob Gyntelberg & Eli M Remolona, 2007. "Risk in carry trades: a look at target currencies in Asia and the Pacific," BIS Quarterly Review, Bank for International Settlements, December.
  14. Jobson, J D & Korkie, Bob M, 1981. "Performance Hypothesis Testing with the Sharpe and Treynor Measures," Journal of Finance, American Finance Association, vol. 36(4), pages 889-908, September.
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