An Effect of Monetary Conditions on Carry Trades

A related paper to:

#5 – FX Carry Trade

Authors: Falconio

Title: Carry Trades and Monetary Conditions

Link: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2854134

Abstract:

This paper investigates the relation between monetary conditions and the excess returns arising from an investment strategy that consists of borrowing low-interest rate currencies and investing in currencies with high interest rates, so-called "carry trade". The results indicate that carry trade average excess return, Sharpe ratio and 5% quantile differ substantially across expansive and restrictive conventional monetary policy before the onset of the recent financial crisis. By contrast, the considered parameters are not affected by unconventional monetary policy during the financial crisis.

Notable quotations from the academic research paper:

"My main result is that carry trade portfolio average return, Sharpe ratio and 5% quantile differ substantially across expansive and restrictive conventional monetary policy before the onset of the recent financial crisis. Specifically, I find that expansive periods are characterised by signicantly higher average returns and Sharpe ratios and lower downside risk. Concerning this, I argue that expansive conventional monetary policy is able to improve market expectations across countries and in this way lower FX volatility risk. This generates a currency appreciation for net debtor nations and an increase in carry trade profits.

Second, I present evidence suggesting that the considered parameters are similar across aggressive and stabilising unconventional monetary policy during the recent financial crisis. So, the Federal Reserve could not affect market expectations during this time.

For investors, this evidence suggests that rewards from carry trade vary with changes in monetary conditions only during "normal" times. For researchers, this evidence suggests that recognising the relevance of monetary policy is crucial to understanding the pricing implications of FX volatility risk for carry trade."

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