FX Carry Trade

The carry trade strategy is probably the most widely known strategy in a currency market. The strategy systematically sells low interest rate currencies and buys high interest rates currencies trying to capture spread between rates. A carry trade strategy is often correlated with global financial and exchange rate stability.

Fundamental reason

In theory, according to uncovered interest rate parity, carry trades should not yield a predictable profit because the difference in interest rates between two countries should equal the rate at which investors expect the low-interest-rate currency to rise against the high-interest-rate one. High interest rate currency often do not fall enough to offset carry trade yield difference between both currencies as inflation is lower then expected in high-interest-rate country. Carry trades also often weaken the currency that is borrowed, because investors sell the borrowed money by converting it to other currencies. Systematic portfolio rebalancing allows capturing these gains.

Markets traded
currencies
Confidence in anomaly's validity
Strong
Notes to Confidence in anomaly's validity
Period of rebalancing
Monthly
Notes to Period of rebalancing
Number of traded instruments
10
Notes to Number of traded instruments
it depends on investor's need for diversification (10-20)
Complexity evaluation
Simple strategy
Notes to Complexity evaluation
Financial instruments
futures, forwards, swaps, CFDs
Backtest period from source paper
1989-2010
Indicative performance
7.49%
Notes to Indicative performance
per annum, performance is calculated from Deutsche Bank Currency Carry USD Index
Estimated volatility
9.70%
Notes to Estimated volatility
volatility is calculated from Deutsche Bank Currency Carry USD Index
Maximum drawdown
-34.55%
Notes to Maximum drawdown
Sharpe Ratio
0.77

Keywords:

carry trade, FX anomaly, forex system

Simple trading strategy

Create an investment universe consisting of several currencies (10-20). Go long 3 currencies with highest central bank prime rates and go short 3 currencies with lowest central bank prime rates. The cash not used as margin is invested on overnight rates. The strategy is rebalanced monthly.

Source Paper

Deutsche Bank
https://index.db.com/htmlPages/DBCR_brochure.pdf
http://quantpedia.com/www/DBCR_Brochure.pdf
Abstract:
Carry - One of the most widely known and profitable strategies in currency markets are carry trades, where one systematically sells low interest rate currencies and buys high interest rate currencies. Such a strategy exploits what a academics call „forward-rate bias“ or the „forward premium puzzle“, that is, the forward rate is not an unbiased estimate of future spot. Put another way, contrary to classical notions off efficient markets, carry trades have made money over time. Academics believe the reason this is possible is that investors who employ the carry trade expose themselves to currency risk. Investors taking this risk are rewarded by positive returns over time.

Other Papers

Lustig, Roussanov, Verdelhan: Common Risk Factors in Currency Markets
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1139447
Abstract: We identify a 'slope' factor in exchange rates. High interest rate currencies load more on this slope factor than low interest rate currencies. As a result, this factor can account for most of the cross-sectional variation in average excess returns between high and low interest rate currencies. A standard, no-arbitrage model of interest rates with two factors - a country-specific factor and a global factor - can replicate these findings, provided there is sufficient heterogeneity in exposure to the global risk factor. We show that our slope factor is a global risk factor. By investing in high interest rate currencies and borrowing in low interest rate currencies, US investors load up on global risk, particularly during bad times.

Acemoglu, Rogoff, Woodford: Carry Trades and Currency Crashes
http://www.nber.org/chapters/c7288.pdf
Abstract: A “naive” investment strategy that chases high yields around the world works remarkably well in currency markets. This strategy is typically referred to as the carry trade in foreign exchange, and it has consistently been very profitable over the last 3 decades.

Kroencke, Schindler, Schrimpf: International Diversification Benefits with Foreign Exchange Investment Styles
http://ftp.zew.de/pub/zew-docs/dp/dp11028.pdf
Abstract: Style-based investments and their role for portfolio allocation have been widely studied by researchers in stock markets. By contrast, there exists considerably less knowledge about the portfolio implications of style investing in foreign exchange markets. Indeed, style-based investing in foreign exchange markets is nowadays very popular and arguably accounts for a considerable fraction in trading volumes in foreign exchange markets. This study aims at providing a better understanding of the characteristics and behavior of style based foreign exchange investments in a portfolio context. We provide a comprehensive treatment of the most popular foreign exchange investment styles over the period from January 1985 to December 2009. We go beyond the well known carry trade strategy and investigate further foreign exchange investment styles, namely foreign exchange momentum strategies and foreign exchange value strategies. We use traditional mean-variance spanning tests and recently proposed multivariate stochastic dominance tests to assess portfolio investment opportunities from foreign exchange investment styles. We find statistically significant and economically meaningful improvements through style-based foreign exchange investments. An internationally oriented stock portfolio augmented with foreign exchange investment styles generates up to 30% higher return per unit of risk within the covered sample period.

Cenedese, Sarno, Tsiakas: Average Variance, Average Correlation and Currency Returns
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2050106
Abstract: This paper provides an empirical investigation of the time-series predictive ability of average variance and average correlation on the return to carry trades. Using quantile regressions, we find that higher average variance is significantly related to large future carry trade losses, whereas lower average correlation is significantly related to large gains. This is consistent with the carry trade unwinding in times of high volatility and the good performance of the carry trade when asset correlations are low. Finally, a new version of the carry trade that conditions on average variance and average correlation generates considerable performance gains net of transaction costs.

Caballero, Doyle: Carry Trade and Systemic Risk: Why are FX Options So Cheap?
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2188195
Abstract: In this paper we document first that, in contrast with their widely perceived excess returns, popular carry trade strategies yield low systemic-risk-adjusted returns. In particular, we show that carry trade returns are highly correlated with the return of a VIX rolldown strategy — i.e., the strategy of shorting VIX futures and rolling down its term structure — and that the latter strategy performs at least as well as betaadjusted carry trades, for individual currencies and diversified portfolios. In contrast, hedging the carry with exchange rate options produces large returns that are not a compensation for systemic risk. We show that this result stems from the fact that the corresponding portfolio of exchange rate options provides a cheap form of systemic insurance.

Della Corte, Riddiough, Sarno: Currency Premia and Global Imbalances
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2280952
Abstract: Global imbalances are a fundamental economic determinant of currency risk premia. We propose a factor that captures exposure to countries' external imbalances - termed the global imbalance risk factor - and show that it explains most of the cross-sectional variation in currency excess returns. The economic intuition of this factor is simple: net foreign debtor countries offer a currency risk premium to compensate investors willing to finance negative external imbalances. Investment currencies load positively on the global imbalance factor while funding currencies load negatively, implying that carry trade investors are compensated for taking on global imbalance risk.

Huang, MacDonald: Currency Carry Trades, Position-Unwinding Risk, and Sovereign Credit Premia
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2287287
Abstract: This is the first study that employs option pricing model to measure the position-unwinding risk of currency carry trade portfolios, which well covers the moment information. We show that high interest-rate currencies are exposed to higher position-unwinding risk than low interest-rate currencies. We also investigate the sovereign CDS spreads as the proxy for countries' credit conditions and find that high interest-rate currencies load up positively on sovereign default risk while low interest rate currencies provide a hedge against it. Sovereign credit premia as the dominant economic fundamental risk, together with position-unwinding likelihood indicator as the market risk sentiment, captures over 90% cross-sectional variations of carry trade excess returns. We identify sovereign credit risk as the impulsive country-specific risk that drives market volatility, and also its global contagion channels. Then We propose an alternative carry trade strategy immunized from crash risk, and a composite story of sovereign credit premia, global liquidity imbalances and liquidity reversal/spiral for explaining the forward premium puzzle.

Hassan, Mano: Forward and Spot Exchange Rates in a Multi-Currency World
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2272893
Abstract: We decompose the covariance of currency returns with forward premia into a cross-currency, a between-time-and-currency, and a cross-time component. The surprising result of our decomposition is that the cross-currency and cross-time-components account for almost all systematic variation in expected currency returns, while the between-time-and-currency component is statistically and economically insignificant. This finding has three surprising implications for models of currency risk premia. First, it shows that the two most famous anomalies in international currency markets, the carry trade and the Forward Premium Puzzle (FPP), are separate phenomena that may require separate explanations. The carry trade is driven by persistent differences in currency risk premia across countries, while the FPP appears to be driven primarily by time-series variation in all currency risk premia against the US dollar. Second, it shows that both the carry trade and the FPP are puzzles about asymmetries in the risk characteristics of countries. The carry trade results from persistent differences in the risk characteristics of individual countries; the FPP is best explained by time variation in the average return of all currencies against the US dollar. As a result, existing models in which two symmetric countries interact in financial markets cannot explain either of the two anomalies.

Jurek, Xu: Option-Implied Currency Risk Premia
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2338585
Abstract: We use cross-sectional information on the prices of G10 currency options to calibrate a non-Gaussian model of pricing kernel dynamics and construct estimates of conditional currency risk premia. We find that the mean historical returns to short dollar and carry factors (HML-FX) are statistically indistinguishable from their option-implied counterparts, which are free from peso problems. Skewness and higher-order moments of the pricing kernel innovations on average account for only 15% of the HML-FX risk premium in G10 currencies. These results are consistent with the observation that crash-hedged currency carry trades continue to deliver positive excess returns.

Hafez, Xie: The Term Structure of Currency Carry Trade Risk Premia
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2340547
Abstract: Investors earn a large carry trade premium by taking long positions in short-term bills issued by countries with high interest rates, funded by short positions in bills issued by countries with low interest rates. We find that the returns to these carry trades disappear as the maturity of the foreign bonds increases. The high-yielding carry trade currencies, whose exchange rates earn a high currency risk premium, have flat yield curves and correspondingly small local term premiums in bond markets. No arbitrage implies that the short-term foreign bond risk premiums are high in the high-yielding countries when there is less overall risk in their pricing kernels than at home. The long-term foreign bond risk premiums are high only when there is less permanent risk in those high-yielding foreign countries' pricing kernels than at home. Our findings imply that the currency carry trade premium in short-term bills compensates investors for exposure to global risk of a transitory nature. The bulk of risk borne by currency investors is less persistent than the overall risks borne by stock investors, because there is more cross-border sharing of permanent risks.

Cen, Marsh: Off the Golden Fetters: Examining Interwar Carry Trade and Momentum
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2358456
Abstract: We study the properties of carry trade and momentum returns in the interwar period, 1921:1-1936:12. We find that currencies with higher interest rates outperform currencies with lower interest rates by about 7% per annum, consistent with estimates from modern samples, while a momentum strategy that is long past winner and short past loser currencies rewards an average annual excess return of around 7% in the interwar sample, larger than its modern counterparts. On the grounds that the interwar period represents rare events better than modern samples, we provide evidence unfavorable to the rare disaster based explanation for the returns to the carry trade and momentum. Global FX volatility risk, however, turns out to account for the carry trade return in the interwar sample as well as in modern samples.

Cenedese, Sarno, Tsiakas: Foreign Exchange Risk and the Predictability of Carry Trade Returns
http://www.uoguelph.ca/~itsiakas/papers/FX_Risk.pdf
Abstract: This paper provides an empirical investigation of the time-series predictive ability of 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.

Lu, Jacobsen: Cross-Asset Return Predictability: Carry Trades, Stocks and Commodities
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2398102
Abstract: Bakshi and Panayotov (2013) find that commodity price changes predict profits from longing high interest rate currencies up to three months later. We find that equity returns also predict carry trade profits, but from shorting low interest rate currencies. Equity effects appear to be slightly faster than commodity effects, as equity price rises predict higher short leg profits over the next two months. The predictability is one-directional from commodities and stocks to carry trades. Our evidence supports gradual information diffusion, rather than time-varying risk premia, as the most likely explanation for the predictability results.

Amen: Beta'em Up: What is Market Beta in FX?
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2439854
Abstract: In asset classes such as equities, the market beta is fairly clear. However, this question is more difficult to answer within FX, where there is no obvious beta. To help answer the question, we discuss generic FX styles that can be used as a proxy for the returns of a typical FX investor. We also look at the properties of a portfolio of these generic styles. This FX styles portfolio has an information ratio of 0.64 since 1976. Unlike its individual components, the FX styles portfolio returns are relatively stable with respect to underlying regimes in S&P500. Later we replicate FX fund returns using a combination of these generic FX styles. We show that a combination of FX trend and carry, can be used as a beta for the FX market. Later, we examine the relationship between bank indices and these generic FX styles. We find that there is a significant correlation in most instances, with some exceptions.

Accominotti, Chambers: Out-of-Sample Evidence on the Returns to Currency Trading
https://research.mbs.ac.uk/accounting-finance/Portals/0/docs/Out-of-Sample%20Evidence%20on%20the%20Returns.pdf
Abstract: We document the existence of excess returns to naïve currency trading strategies during the emergence of the modern foreign exchange market in the 1920s and 1930s. This era of active currency speculation constitutes a natural out-of-sample test of the performance of carry, momentum and value strategies well documented in the modern era. We find that the positive carry and momentum returns in currencies over the last thirty years are also present in this earlier period. In contrast, the returns to a simple value strategy are negative. In addition, we benchmark the rules-based carry and momentum strategies against the discretionary strategy of an informed currency trader: John Maynard Keynes. The fact that the strategies outperformed a superior trader such as Keynes underscores the outsized nature of their returns. Our findings are robust to controlling for transaction costs and, similar to today, are in part explained by the limits to arbitrage experienced by contemporary currency traders.

Daniel, Hodrick, Lu: The Carry Trade: Risks and Drawdowns
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2486275
Abstract: We examine carry trade returns formed from the G10 currencies. Performance attributes depend on the base currency. Dynamically spread-weighting and risk-rebalancing positions improves performance. Equity, bond, FX, volatility, and downside equity risks cannot explain profitability. Dollar-neutral carry trades exhibit insignificant abnormal returns, while the dollar exposure part of the carry trade earns significant abnormal returns with little skewness. Downside equity market betas of our carry trades are not significantly different from unconditional betas. Hedging with options reduces but does not eliminate abnormal returns. Distributions of drawdowns and maximum losses from daily data indicate the importance of time-varying autocorrelation in determining the negative skewness of longer horizon returns.

Orlov: Currency Momentum, Carry Trade and Market Illiquidity
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2480429
Abstract: This study empirically examines the effect of equity market illiquidity on the excess returns of currency momentum and carry trade strategies. Results uniformly show that equity market illiquidity explains the evolution of strategy payoffs, consistent with a liquidity-based model. Comprehensive experiments, using both time-series and cross-sectional specifications, show that returns on the strategies are low (high) following months of high (low) equity market illiquidity. This effect is found to withstand various robustness checks and is economically significant, approximating in value to one-third of average monthly profits.

Bae, Elkamhi: Global Equity Correlation in Carry and Momentum Trades
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2521608
Abstract: We provide a risk-based explanation for the excess returns of two widely-known currency speculation strategies: carry and momentum trades. We construct a global equity correlation factor and show that it explains the variation in average excess returns of both these strategies. The global correlation factor has a robust negative price of beta risk in the FX market. We also present a multi-currency model which illustrates why heterogeneous exposures to our correlation factor explain the excess returns of both portfolios.

Doskov, Swinkels: Empirical Evidence on the Currency Carry Trade, 1900-2012
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2060207
Abstract: Most of the currency literature investigates the risk and return characteristics of the currency carry trade after the collapse of the Bretton Woods system. In order to gauge the long-term currency carry premium, we extend the sample to 20 currencies over the period 1900 to 2012. We find modest Sharpe ratios in the range of 0.2 to 0.4 for carry trading over this period. This is markedly lower than the Sharpe ratios above 0.6 reported for recent sample periods. We document that carry trading occasionally incurs substantial losses, which fits well with risk-based explanations for deviations from uncovered interest parity. We find that large carry trading losses do not necessarily coincide with large losses in global equity markets. Our results help to better understand the source and nature of excess returns on the carry trade.

Reichenecker: Currency Carry Trade Portfolios and Its Sensitivity to Interest Rates
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2517467
Abstract: This paper provides an empirical investigation of 5 different optimized carry trade portfolios and four naïve carry trade portfolio for G10 and emerging market currencies. It is shown that optimized carry trade portfolios have smaller downside and crash risk, are less correlated to the global market portfolio, and are more profitable during the recent financial crises, than naïve carry trade portfolios. Contrarily to naïve carry trade portfolio, risk and return measures of optimized currency carry trade portfolios have a linear relationship with a single implied interest rate shock. Sensitivities can be used to conduct the market risk for optimized currency carry trade portfolios.

Ganepola: Carry Trades and Tail Risk of Exchange Rates
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2555805
Abstract: Historically, Carry trades have been a success story for most investor and a major source of funds for emerging economies maintaining higher interest rates. Therefore it’s a timely topic to investigate the risk embedded in such transactions and to what extent the carry trade returns explain the tail risk. Initially, this research estimates the tail index of all the currencies and formulates a unique inverse function for all the currencies in relation to Power laws, with the idea of estimating the respective Value-at-Risk. This research considers twenty five currencies and replicates them in to five portfolios based on the annualised daily return of a weekly forward contract. Trade was executed assuming a U.S. investor, who goes long in a high return portfolio and short in a low return portfolio. The results indicate that tail risk cannot be explained effectively by its returns because of its exponential nature. However, I find that tail risk is mostly influenced by the long position of the carry trade. Furthermore, the return of the foreign exchange component appears to have a better explanation on the tail risk compared to the interest rate return. The Value-at-Risk analysis also suggests that the tail risk of overall strategy is influenced by the tail risk of foreign exchange component embedded in the long position of the trade.

Pojarliev, Levich: A New Look at Currency Investing
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2571391
Abstract: The authors of this book examine the rationale for investing in currency. They highlight several features of currency returns that make currency an attractive asset class for institutional investors. Using style factors to model currency returns provides a natural way to decompose returns into alpha and beta components. They find that several established currency trading strategies (variants of carry, trend-following, and value strategies) produce consistent returns that can be proxied as style or risk factors and have the nature of beta returns. Then, using two datasets of returns of actual currency hedge funds, they find that some currency managers produce true alpha. Finally, they find that adding to an institutional investor’s portfolio even a small amount of currency exposure — particularly to alpha generators — can make a meaningful positive impact on the portfolio’s performance.

Olszweski, Zhou: Strategy diversification: Combining momentum and carry strategies within a foreign exchange portfolio
http://apps.olin.wustl.edu/faculty/zhou/O_Z_JHDF_2014.pdf
Abstract: Hedge funds, such as managed futures, typically use two different types of trading strategies: technical and macro/fundamental. In this article, we evaluate the impact of combining the two strategies, and focus on, in particular, two common foreign exchangetrading strategies: momentum and carry. We find evidence that combining the strategies offers a significant improvement in risk-adjusted returns. Our analysis, which uses data spanning 20 years, highlights the potential benefits of achieving strategy-level diversification.

Maurer, To, Tran: Pricing Risks Across Currency Denominations
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2589545
Abstract: Investors based in different countries earn different returns on same strategies because the same risks covary differently with countries' stochastic discount factors (SDFs). We document that investors in low-interest-rate countries earn more than those in high-interest-rate countries on identical carry trade strategies. We propose a novel econometric procedure to estimate country-specific SDFs from foreign exchange market data. We provide out-of-sample evidence that (i) a country's interest rate is inversely related to its SDF volatility, (ii) output gap fluctuations across countries strongly correlate with estimated SDFs, and (iii) our estimated SDFs explain half of the risk in equity markets as measured by priced equity premia.

Nunes, Piloiu: Uncovered Interest Rate Parity: A Relation to Global Trade Risk
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2595165
Abstract: The paper gives evidence of a novel pricing factor for the cross-section of carry trade returns based on trade relations between countries. In particular, we apply network theory on countries' bilateral trade to construct a measure for countries' exposure to a global trade risk. A higher level of exposure implies that the economic activity in one country is highly dependent on the economic activity of its trade partners and on aggregate trade flow. We test the following hypothesis for carry trade strategies: high interest rate currencies are more exposed to global trade risk than low interest rates ones. We find empirically that low interest rate currencies are seen by investors as a hedge against global trade risk while high interest rate currencies deliver low returns when global trade risk is high, being negatively related to the global trade risk factor. These results provide evidence on the underlying macroeconomic sources of systematic risk in FX markets while accounting as well for other previously documented risk factors, such as the market factor and the volatility and liquidity risks.

Bekaert, Panayotov: Good Carry, Bad Carry
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2600366
Abstract: We distinguish between "good" and "bad" carry trades constructed from G-10 currencies. The good trades exhibit higher Sharpe ratios and slightly negative or even positive skewness, in contrast to the bad trades that have both substantially lower Sharpe ratios and skewness. Surprisingly, good carry trades do not involve the most typical carry trade currencies like the Australian dollar and Japanese yen. The distinction between good and bad trades significantly alters our understanding of currency carry trade returns. It invalidates, for example, explanations invoking return skewness and crash risk, as the negative return skewness is induced by the typical carry currencies. We find strong predictability with previously identified carry return predictors for bad, but not good carry trade returns. In addition, a static carry component explains a much larger proportion of bad carry trade returns, than of good carry trade returns. Furthermore, good carry trade returns perform better than bad carry trade returns as a risk factor, explaining the returns of interest-rate sorted currency portfolios, and in turn are better explained with equity market risk factors.

Clare, Seaton, Smith, Thomas: Carry and Trend Following Returns in the Foreign Exchange Market
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2633752
Recent research has confirmed the behaviour of traders that significant excess returns can be achieved from following the predictions of the carry trade which involves buying currencies with relatively high short-term interest rates, or equivalently a high forward premium, and selling those with relatively low interest rates. This paper shows that similar-sized excess returns can be achieved by following a trend-following strategy which buys long positions in currencies that have achieved positive returns and otherwise holds cash. We demonstrate that market risk is an important determinant of carry returns but that the standard unconditional CAPM is inadequate in explaining the cross-section of forward premium ordered portfolio returns. We also show that the downside risk CAPM fails to explain this cross-section, in contrast to recent literature. A conditional CAPM which makes the impact of the market return as a risk factor depend on a measure of market liquidity performs very well in explaining more than 90% of the variation in portfolio returns and more than 90% of the average returns to the carry trade. Trend following is found to provide a significant hedge against these risks. The performance of the trend following factor is more surprising given that it does not have the negative skewness or maximum drawdown characteristic which is shown by the carry trade factor.

Breedon, Rime, Vitale: Carry Trades, Order Flow and the Forward Bias Puzzle
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2643531
Abstract: We investigate the relation between foreign exchange (FX) order flow and the forward bias. We outline a decomposition of the forward bias according to which a negative correlation between interest rate differentials and order flow creates a time-varying risk premium consistent with that bias. Using ten years of data on FX order flow we find that more than half of the forward bias is accounted for by order flow --- with the rest being explained by expectational errors. We also find that carry trading increases currency-crash risk in that order flow generates negative skewness in FX returns.

Ready, Roussanov, Ward: Commodity Trade and the Carry Trade: A Tale of Two Countries
http://jacobslevycenter.wharton.upenn.edu/wp-content/uploads/2015/05/Commodity-Trade-and-the-Carry-Trade-4.3.15.pdf
Abstract: Persistent differences in interest rates across countries account for much of the profitability of currency carry trade strategies. The high-interest rate "investment" currencies tend to be "commodity currencies," while low interest rate "funding" currencies tend to belong to countries that export finished goods and import most of their commodities. We develop a general equilibrium model of international trade and currency pricing in which countries have an advantage in producing either basic input goods or final consumable goods. The model predicts that commodity-producing countries are insulated from global productivity shocks through a combination of trade frictions and domestic production, which forces the final goods producers to absorb the shocks. As a result, the commodity country currency is risky as it tends to depreciate in bad times, yet has higher interest rates on average due to lower precautionary demand, compared to the nal-good producer. The carry trade risk premium increases in the degree of specialization, and the real exchange rate tracks relative technological productivity of the two countries. The model's predictions are strongly supported in the data.

Jung, Lee: A Liquidity-Based Resolution of the Uncovered Interest Parity Puzzle
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2685534
Abstract: A new monetary theory is set out to resolve the "Uncovered Interest Parity (UIP)" Puzzle. It explores the possibility that liquidity properties of money and nominal bonds can account for the puzzle. A key concept in our model is that nominal bonds carry liquidity premia due to their medium of exchange role as either collateral or means of payment. In this framework no-arbitrage ensures a positive comovement of real return on money and nominal bonds. Thus, when inflation in one country becomes relatively lower, i.e., real return on this currency is relatively higher, its nominal bonds should also yield higher real return. We show that their nominal returns can also become higher under the economic environment where collateral pledgeability and/or liquidity of nominal bonds and/or collateralized credit based transactions are relatively bigger. Since a currency with lower inflation is expected to appreciate, the high interest currency does indeed appreciate in this case, i.e., the UIP puzzle is no longer an anomaly in our model. Our liquidity based theory can in fact help understanding many empirical observations that risk based explanations find difficult to reconcile with.

Abankwa, Blenman: FX Liquidity Risk and Carry Trade Returns
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2662955
Abstract:
We study the effects of FX liquidity risk on carry trade returns using a low-frequency market-wide liquidity measure. We show that a liquidity-based ranking of currency pairs can be used to construct a mimicking liquidity risk factor, which helps in explaining the variation of carry trade returns across exchange rate regimes. In a liquidity-adjusted asset pricing framework, we show that the vast majority of variation in carry trade returns during any exchange rate regime can be explained by two risk factors (market and liquidity risk) in the FX market. Our results are further corroborated when the hedge liquidity risk factor is replaced with a non-tradable innovations risk factor.