FX Carry Trade

Fundamental reason

Simple trading strategy

Out-of-sample strategy's implementation/validation in QuantConnect's framework(chart, statistics & code)

Source paper

Deutsche Bank

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

  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

  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

  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

  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?

  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

  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

  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

  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

  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

  Abstract: 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

  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

  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

  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?

  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

  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

  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

  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

  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

  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

  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

  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

  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

  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

  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

  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

  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

  Abstract: 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

  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

  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

  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

  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.

• Fratzcher, Menkhoff, Sarno, Schmeling, Stoehr: Systematic Intervention and Currency Risk Premia

  Abstract: Using data for the trades of 19 central banks intervening in currency markets, we show that leaning against the wind by individual central banks leads to "systematic intervention" in the aggregate central banking sector. This systematic intervention is driven by and impacts on the same factors that drive currency excess returns: carry, momentum, value, and a dollar factor. The sensitivity of an individual central bank's intervention to these factors differs markedly across countries, with developed countries making a profit from intervention and emerging markets incurring large losses.

• Hasselgren: Herding, Hedge Funds, and the Carry Trade

  Abstract: I study hedge fund herding patterns in currency futures contracts and find evidence of herding. High-interest (low-interest) currencies exhibit higher buy-side (sell-side) herding, consistent with carry trade positions. A strategy herding measure is then proposed that is used to track hedge fund herding in the carry trade strategy. I find that hedge fund carry trade strategy herding positively predicts future returns, a result that is robust to a host of other activity measures. I do not find hedge fund herding to be destabilizing, and investors can improve performance by following hedge fund herding behaviour in the carry trade.

• Byrne, Ryuta: The Conditional Risk and Return Trade-Off on Currency Portfolios

  Abstract: If asset price risk-return relations vary over time based upon changing economic states, standard unconditional models may “wash out” state dependence and fail to identify that additional risk is contingently compensated with higher return. We address this matter by considering conditional risk-return relations for currency portfolios. Doing so within a data rich environment, we also develop broad based measures of investor risk. In general we find that agents require positive compensation for risks in some times and for some investment strategies. Our results identify that relations between currency returns and risk vary over time. Also we find that there are positive risk-return relations on momentum and value currency portfolios during the financial crisis. Furthermore, the risk-return relation on the momentum portfolio is counter-cyclical.

• Dai, Wei and Schneller, Warwick, To Hedge or Not to Hedge: A Framework for Currency Hedging Decisions in Global Equity & Fixed Income Portfolios

  Abstract: This paper develops a framework for evaluating the impact of currency hedging on expected returns and volatility and tests the implications for global equity and fixed income portfolios using data on 12 developed markets from 1985 to 2019. We show that the impact of currency hedging on overall portfolio volatility depends on the magnitude of asset volatility relative to that of currency volatility. We also find that currency returns cannot be reliably predicted using the prior month currency returns or interest rate differentials. The forward currency premium, however, contains reliable information about differences in expected returns between unhedged and hedged portfolios, and can be used to pursue higher expected returns through a selectively hedged strategy.

• Panayotov, George, Currency Puzzles and the Oil Connection

  Abstract: Recent studies document the reversal of several long-standing puzzles in the currency market, including the forward premium puzzle, carry trade profitability and the exchange rate "disconnect". We provide a common framework for understanding these reversals, consistent with the structural breaks that we find in currency returns at the end of 2005. These reversals can be explained by a shift in the relative importance of the global and local risk factors that drive currency returns. We link this shift to developments in the U.S. oil sector, and more generally in the U.S. real economy, that originate around 2005.

• Kohlscheen, Emanuel and Avalos, Fernando Hugo and Schrimpf, Andreas: When the Walk is Not Random: Commodity Prices and Exchange Rates

  Abstract: We show that there is a distinct commodity-related driver of exchange rate movements, even at fairly high frequencies. Commodity prices predict exchange rate movements of eleven commodity-exporting countries in an in-sample panel setting for horizons up to two months. We also find evidence of systematic (pseudo) out-of-sample predictability, overturning the results of Meese and Rogoff (1983): information embedded in our country-specific commodity price indexes clearly helps to improve upon the predictive accuracy of the random walk in the majority of countries. We further show that the link between commodity prices and exchange rates is not driven by changes in global risk appetite or carry.

• Nissinen, Juuso and Suominen, Matti and Ferreira Filipe, Sara, Currency Carry Trades and Global Funding Risk

  Abstract: We measure funding constraints in international currency markets by deviations in the covered interest rate parity. Our measure of funding risk is the standard deviation of the magnitude of the funding constraints. This funding risk measure appears to be driven by conditions in the financial sector in the low interest rate, so called carry trade short countries, oil price volatility, as well as by the actions of the main central banks. Although funding risk has been present throughout our sample, it becomes only relevant in currency carry trading after 2008, suggesting that investors’ funding constraints start binding at that time. We document evidence that since 2008 funding risk has affected the magnitude of currency carry trading activity, carry trade returns, correlation between carry long and short currencies, relative equity returns in carry trade long vs. short countries, and the economies of carry trade long countries measured through changes in industrial production. We develop a theory of currency markets under funding constraints that has several testable implications. For instance, as funding constraints start to bind, our theory predicts that both the investment and funding currencies drop relative to a safe asset. This result is observable also in our empirical analysis, when we proxy for the safe asset with gold. In line with theory, funding risk forecasts currency crashes in the carry trade long and short countries.

• Demirer, Riza and Yuksel, Asli and Yuksel, Sadettin Aydin: Time-Varying Risk Aversion and Currency Excess Returns

  Abstract: This paper documents an economically significant risk premium associated with a currency’s sensitivity to time-varying risk aversion. Consequently, an investment strategy that takes a long (short) position in currencies with high (low) sensitivity to the aggregate market risk aversion yields significantly positive excess returns. While advanced market currencies including the Euro, Yen and Swiss Francs dominate the short end of these portfolios with low sensitivity to risk aversion, emerging market currencies including the Brazilian Real, Mexican Peso and Turkish Lira are found to be the most sensitive currencies to risk aversion. The excess returns from the proposed strategy are significant even after controlling for systematic equity market risk factors as well as liquidity risk and cannot be explained by measures of economic conditions or uncertainty. Interestingly the excess returns generated by the risk aversion based strategy are found to have significant loadings on global momentum, suggesting possible commonality in the behavioral drivers of anomalies in the global equity and currency markets. The findings highlight the role of behavioral factors as predictor of currency excess returns with significant investment implications.

• Kim, Sun Yong and Saxena, Konark: Long Run Risks in FX Markets: Are They There?

  Abstract: This paper documents a tight connection between long run consumption risks (LRRs), currency excess returns and traditional global currency risk factors. We adopt a novel identification strategy that estimates country level LRRs using asset market data alone. With this identification strategy in hand, we find that: (1) currencies that suffer a bad relative LRR shock appreciate on impact before depreciating over the long run, (2) the High-Minus-Low (HML) carry trade sorts currencies on the basis of global LRR exposures, (3) the dollar carry trade outperforms on impact before underperforming over the long run in response to positive US relative LRR shocks, (4) US relative LRR shocks drive global currency risk factors. We interpret these facts as evidence in favour of an international LRR model where US LRRs drives the global exchange rate factor structure.

• Söderlind, Paul and Somogyi, Fabricius: FX Liquidity Risk and Carry Trade Premia

  Abstract: The foreign exchange (FX) market is considered to be the largest and presumably most liquid financial market in the world. We show that even in this market exposure to liquidity risk commands a non-trivial risk premium of up to 3.6% per annum. In particular, systematic and currency-specific liquidity risk are not subsumed by existing risk factors and successfully price the cross-section of currency returns. However, we also find that liquidity and carry trade premia are significantly correlated. This lends support to a liquidity-based explanation of the carry trade risk premium. To illustrate this point, we decompose carry trade returns and show that the commonality with liquidity risk stems from periods of high market stress and is confined to the static but not the dynamic carry trade.

• Granziera, Eleonora and Sihvonen, Markus Bonds: Currencies and Expectational Errors

  Abstract: We propose a model in which sticky expectations concerning short-term interest rates generate joint predictability patterns in bond and currency markets. Using our calibrated model, we quantify the effect of this channel and find that it largely explains why short rates and yield spreads predict bond and currency returns. The model also creates a downward sloping term structure of carry trade returns, difficult to replicate in a rational expectations framework. Including a sticky short rate expectations channel into a standard affine term structure model improves its fit and allows the model to better capture the drift patterns in the data.

• Mokanov, Denis: Deviations from Rational Expectations and the Uncovered Interest Rate Parity Puzzle

  Abstract: This paper documents a novel result regarding the uncovered interest rate parity (UIP) puzzle: investing in high interest rate currencies does not yield positive excess returns during recessions. That is, the UIP holds in bad times. This new finding is a challenge to existing rational expectations models that address the UIP puzzle. A model featuring investors whose interest rate expectations are distorted by extrapolation bias and time-varying stickiness is able to quantitatively account for this evidence when calibrated to available survey data. The model also generates predictions for bond return predictability, the profitability of time-series momentum in the foreign exchange and fixed income markets, and foreign exchange predictability during the post-2007 period, which are borne out in the data.

• Institute for Monetary and Financial Research, Hong Kong: FX Arbitrage and Market Liquidity: Statistical Significance and Economic Value

  Abstract: This working paper was written by Wai-Ming Fong (The Chinese University of Hong Kong), Giorgio Valente (University of Leicester) and Joseph K. W. Fung (Hong Kong Baptist University). This paper studies covered interest parity arbitrage violations in foreign exchange markets and their relationship with market liquidity using a novel and unique dataset of tick-by-tick firm quotes for all financial instruments involved in the arbitrage strategy. The statistical analysis reveals that arbitrage opportunities are larger in size and slower to dissipate when market liquidity is poorer. Furthermore, their economic value is sizable but arbitrage profits only accrue to traders who are able to obtain low trading costs. These findings are consistent with a competitive equilibrium with real frictions when some traders have a comparative advantage in arbitrage trading.

• Chernov, Mikhail and Dahlquist, Magnus and Lochstoer, Lars A.: An Anatomy of Currency Strategies: The Role of Emerging Markets

  Abstract: We show that a small set of emerging markets with floating exchange rates expand the investment frontier substantially relative to G10 currencies. The frontier is characterized by an out-of-sample mean-variance efficient portfolio that prices G10- and emerging markets-based trading strategies unconditionally as well as conditionally. Our approach reveals that returns to prominent trading strategies are largely driven by factors that do not command a risk premium. After real-time hedging of such unpriced risks, the Sharpe ratios of these strategies increase substantially, providing new benchmarks for currency pricing models. For instance, the Sharpe ratio of the carry strategy increases from 0.71 to 1.29. The unpriced risks are related to geographically-based currency factors, while the priced risk that drives currency risk premiums is related to aggregate consumption exposure.

• Castro, Pedro and Hamill, Carl and Harber, John and Harvey, Campbell R. and van Hemert, Otto: The Best Strategies for FX Hedging

  Abstract: The question of whether, when, and how to hedge foreign exchange risk has been a vexing one for investors since the end of the Bretton Woods system in 1973. Our study provides a comprehensive empirical analysis of dynamic FX hedging strategies over several decades, examining various domestic and foreign currency pairs. While traditional approaches often focus on risk mitigation, we explore the broader implications for expected returns, highlighting the interplay between hedging and strategies such as the carry trade. Our findings reveal that incorporating additional factors-such as trend (12-month FX return), value (deviation from purchasing power parity), and carry (interest rate differential) - into hedging decisions delivers significant portfolio benefits. By adopting a dynamic, active approach to FX hedging, investors can enhance returns and manage risk more effectively than with static hedged or unhedged strategies.