New research paper shows how to easily improve #5 – FX Carry Trade

"We examine an alternative model of the impact on carry returns of the interaction of standard market risk and measures of market liquidity risk. The literature on the carry trade has examined a wide range of possible risk and non-risk based explanations for the size and time series behaviour of carry returns. The key features are a significant high and persistent average return but one which displays significant negative skewness. Estimates of standard
models and risk factors have shown only a weak relationship between risk factors and carry returns. Small and insignificant betas have been coupled with even smaller and less significant prices of risk.

Market liquidity has been identified as a potential source of risk in all financial markets.Here we show that the critical issue is the interaction of the market liquidity and markets factors. We show that carry returns are high
due to increased exposure to market risk due to reduced market liquidity. This can be viewed as a more nuanced version of the downside CAPM model of Lettau, Maggiori and Weber (2014) and Dobrynskaya (2014) which focus only on the ‘down market state’. We find, in common with Daniel, Hodrick and Lu (2014), that the key parameters of the downside CAPM model are small and insignificant and cannot generate a positive risk premium for the carry trade. In contrast, we show that the market liquidity CAPM model can explain a great deal of the variation in both the level of carry trade returns and the cross-section of interest rate ordered currency returns and that this does not depend on the precise definition of market liquidity risk.

From an investor’s point of view, the heavily negatively skewed returns offered by the carry trade are mostly explained as compensation for exposure to the risk factors we identify. Alternative strategies offer the opportunity to hedge these risks. We show that trend following offers a simple hedge for the risks that are priced by the carry trade whilst generating a significant unexplained average return of a similar order of magnitude to that offered by carry. Thus, when combined with a trend following overlay, the combined strategy generates an average return well above that of the individual components. This increased average return also has desirable characteristics in terms of higher moments; it offers a higher Sharpe ratio and positive skewness as well as a smaller maximum drawdown than the components or alternative strategies."

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