Two Recent Papers Related to FX Carry Strategy

Two academic papers related to:

#5 – FX Carry Trade


1. Volatility and liquidity risk factors explain Carry strategy:

Authors: Shehadeh, Li, Moore

Title: The Forward Premium Bias, Carry Trade Return and the Risks of Volatility and Liquidity



In this paper, we analyse the relationship between the currency carry return and volatility and liquidity risk factors. We find that both categories of risk factors are relevant to understanding and explaining carry return, with an outperformance for volatility ones especially the global FX volatility risk factor. Consistent with the poor performance of currency carry trades during high FX volatility regime, we also show that the well-established negative slope coefficient in the Fama regression tends to be more positive and even above unity in times of high FX volatility. The paper, overall, contributes to the risk-based solution of the forward premium bias puzzle.


2. FX variance and negative skewness risk factors explain Carry strategy:

Authors: Broll

Title: The Carry Trade and Implied Moment Risk



The carry trade is a zero net investment strategy that borrows in low yielding currencies and subsequently invests in high yielding currencies. It has been identified as highly profitable FX strategy delivering significantly excess returns with high Sharpe ratios. This paper shows that these excess returns are especially compensation for bearing FX variance and negative skewness risk. Additionally, factor risks that affect foreign money changes, foreign inflation changes, as well as changes to a newly developed Carry Trade Activity Index and the VIX index, as a proxy for global risk aversion, make up the carry trade risk anatomy. These findings are not exclusively important for carry traders, but also contribute to the understanding of currency risk in the cross-section. This is directly linked to asset pricing tests from Lustig et al. (2011), which have shown that currency baskets sorted on their interest rate differentials are all exposed to carry trade returns as a risk factor. Furthermore, this paper finds evidence that a decreased level of funding liquidity potentially leads to carry trade unwindings, controlling for equity and FX implied variance and skewness effects, which supports the theoretical model of liquidity spirals developed by Brunnermeier and Pedersen (2009).



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