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Foreign Exchange Risk and the Predictability of Carry Trade Returns

Listed author(s):
  • Gino Cenedese

    ()

    (Bank of England, UK)

  • Lucio Sarno

    (City University London, UK; CEPR, UK)

  • Ilias Tsiakas

    ()

    (University of Guelph, Canada)

This paper provides an empirical investigation of the time-series predictive ability of foreign exchange risk measures on the return to the carry trade, a popular investment strategy that borrows in low-interest currencies and lends in high-interest currencies. Using quantile regressions, we find that higher market variance is significantly related to large future carry trade losses, which is consistent with the unwinding of the carry trade in times of high volatility. The decomposition of market variance into average variance and average correlation shows that the predictive power of market variance is primarily due to average variance since average correlation is not significantly related to carry trade returns. Finally, a new version of the carry trade that conditions on market variance generates performance gains net of transaction costs.

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File URL: http://www.rcfea.org/RePEc/pdf/wp02_14.pdf
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Paper provided by The Rimini Centre for Economic Analysis in its series Working Paper Series with number 02_14.

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Date of creation: Feb 2014
Publication status: Published in Journal of Banking and Finance, 42:302-313, 2014
Handle: RePEc:rim:rimwps:02_14
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