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Create account Login Subscribe. The carry trade — borrowing in currencies with low interest rates and investing in currencies with high interest rates — has been a surprising hit for decades. This column provides empirical evidence suggesting that the mysteriously high returns this generates can actually be explained as compensation for the volatility risk undertaken. Traders borrow in currencies with low interest rates negative forward premium and invest in currencies with high interest rates positive forward premium , profiting from the margin.
Yet according to the uncovered interest parity this strategy should not work. If investors are both rational and risk-neutral, then exchange-rate changes will eliminate any gain arising from the differential in interest rates across countries.
It is well documented, however, that exchange-rate changes do not compensate for the interest-rate differential. If anything, the opposite holds true empirically — high-interest-rate currencies tend to appreciate while low-interest-rate currencies tend to depreciate. Considering the very liquid foreign-exchange markets, the dismantling of barriers to capital flows between countries, and the existence of international currency speculation during this period, it is difficult to understand why carry trades have been profitable for such a long time.
A simple and theoretically convincing solution for this puzzle is the consideration of time-varying risk premia. However, the empirical literature has serious problems to convincingly identify risk factors that drive these premia until today. In a recent paper we suggest a resolution Menkhoff et al. We start by sorting currencies into portfolios according to their forward premium or, equivalently, their relative interest-rate differential versus US money market interest rates at the end of each month, as first proposed in academic research by Lustig and Verdelhan We form five such portfolios.
Investing in the highest relative interest-rate quintile, i. These returns cannot be explained by standard measures of risk e. We argue that these high returns to currency carry trades can indeed be understood as a compensation for risk.
Finance theory predicts that investors are concerned about variables affecting the evolution of the investment opportunities and wish to hedge against unexpected changes innovations in market volatility, leading risk-averse agents to demand currencies that can hedge against this risk. We test whether the sensitivity of excess returns to global foreign-exchange volatility risk can rationalise the returns to currency portfolios in a standard asset-pricing framework.
We find that high-interest-rate currencies are negatively related to innovations in global foreign-exchange volatility and thus deliver low returns in times of unexpectedly high volatility, when low interest rate currencies provide a hedge by yielding positive returns.
To prove this point, we carry out the empirical analysis using data for spot exchange rates and 1-month forward exchange rates versus the dollar over the sample period from November to August , obtained from BBI and Reuters via Datastream. The total sample consists of 48 countries, but we also study a smaller sub-sample consisting of only 15 developed countries with a longer data history. From these data, we construct carry-trade portfolios and examine their excess returns. We also construct a proxy for global foreign-exchange volatility, which is simply the cross-sectional standard deviation of volatility across all currencies in the portfolio, calculated month by month from daily data.
Figure 1 shows cumulative returns for the carry-trade portfolio for all countries and for the smaller sample of developed countries. Shaded areas correspond to NBER-defined recessions. Interestingly, carry trades among developed countries were more profitable in the 80s and 90s; only in the last part of the sample did the inclusion of emerging markets' currencies improve returns to the carry trade. Also, the two recessions in the early 90s and s did not have any significant influence on returns.
It is only in the last recession -- that also saw a massive financial crisis -- that carry-trade returns show some sensitivity to macroeconomic conditions. By and large, most of the major spikes in carry-trade returns e. The graph also shows our proxy for global foreign-exchange volatility and its innovations, which appears to pick up obvious times of turmoil, including the recent financial crisis.
Figure 2 provides a graphical analysis to illustrate our point we carry out extensive tests to establish our results in our paper. We visualise the relationship between global foreign-exchange volatility risk and currency excess returns.
To do so, we divide the sample into four sub-samples depending on the value of global foreign-exchange volatility innovations. We then calculate average excess returns for these sub-samples for the return difference between portfolio 5 and 1. Results are shown in Figure 2 for the sample of all countries and for the smaller sample of 15 developed countries.
Bars show the annualised mean returns of the carry-trade portfolio. As can be seen from the figure, high-interest-rate currencies clearly yield higher excess returns when volatility risk is low and vice versa.
Average excess returns for the long-short portfolios decrease monotonically when moving from the low to the high-volatility states for the sample of developed countries, and almost monotonically for the full sample of countries.
While this analysis is intentionally simple, it intuitively demonstrates a clear relationship between global foreign-exchange volatility innovations and returns to carry-trade portfolios. This point can be seen visually in Figure 3, which shows the mean excess returns from the five portfolios the actual data and the corresponding mean excess returns predicted by the asset pricing model based on our global volatility risk variable. Essentially, we obtain almost a 45 degree line, indicating that the volatility-risk proxy captures almost fully the variation in portfolio returns.
We propose a measure of global foreign-exchange volatility innovations as a systematic risk factor that explains the returns from carry trades. There is a significantly negative co-movement of high-interest-rate currencies carry-trade-investment currencies with global foreign-exchange volatility innovations, whereas low-interest-rate currencies carry-trade-funding currencies provide a hedge against unexpected volatility changes.
Further analysis shows that liquidity risk also matters for the cross-section of currency returns, albeit to a lesser degree. These results also extend to other cross-sections of asset returns such as individual currency returns, equity momentum, and corporate bonds.
Exchange rates International finance. The risk in carry trades Lukas Menkhoff, Lucio Sarno, Maik Schmeling, Andreas Schrimpf 23 March The carry trade — borrowing in currencies with low interest rates and investing in currencies with high interest rates — has been a surprising hit for decades. What is the risk in carry trades?
Cumulative carry trade returns Figure 2 provides a graphical analysis to illustrate our point we carry out extensive tests to establish our results in our paper. Distribution of global foreign-exchange volatility All Countries Developed countries Bars show the annualised mean returns of the carry-trade portfolio. How well does this risk explain the returns to carry trades? Realised mean excess returns All countries Developed countries Conclusion We propose a measure of global foreign-exchange volatility innovations as a systematic risk factor that explains the returns from carry trades.
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