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Foreign Exchange

FX carry mystery explained: strategies’ returns a reward for risk taking

A new study has uncovered why FX carry trade strategies persistently deliver returns, helping solve a mystery that has long vexed academics.

Carry trade strategies, in which the purchase of high-yielding currencies are financed by selling low-yielding ones, should not produce excess returns, according to uncovered interest parity theory. That is because the theory suggests currencies of low-interest rate countries should appreciate to compensate for lower returns.

However, history has shown the opposite to be the case, with currencies sporting high interest rates outperforming lower yielding ones.

Indeed, a new study from Leibniz University, Cass Business School and the Bank for International Settlements – which claims to be the largest ever analysis of the carry trade – finds that the strategy delivers excess returns of more than 5 % a year, even after accounting for transaction costs and recent market turmoil.

The study analysed spot FX and one-month forward exchange rates for the currencies of 48 countries against the US dollar.

It found that carry trades among developed countries was most profitable in the 1980s and 1990s, while the two recessions in the early 1990s and 2000s did not have an obvious influence on returns. It is only during the recent recession and financial crisis that returns have fallen.

 Carry trades and global FX volatility

 
 Source: The Journal of Finance

The paper found empirical evidence that high interest-rate currencies are negatively related to unexpected changes in market volatility – which it terms volatility innovations – delivering low returns in times of unexpectedly high volatility, when low interest-rate currencies provide a hedge by yielding positive returns.

Professor Lucio Sarno, from Cass Business School, co-author of the report and a former head of currency research at Axa Investment Managers, says the excess returns from carry trades can therefore be explained as a “compensation for risk”, given strategies’ vulnerability to sudden shocks.

“Given the very liquid foreign exchange markets, the dismantling of barriers to capital flow between countries and the existence of international currency speculation during this period, it is difficult to understand why carry trades have been profitable for such a long time,” he says.

“Our study shows that high returns to currency carry trades can be understood as a compensation for risk.”

Carry trade returns can, in other words, be rationalized from the perspective of standard asset pricing, with investors being compensated for taking the risk that asset markets might tank.

Sarno says timing when to abandon carry trades is difficult, given that, by definition, shocks cannot be predicted.

The only other way to hedge a carry trade position, he says, is by going long on volatility, buying a structure that pays positive returns when carry trades incur losses.

“This calls for the use of variance swaps or complex combinations of currency options to hedge the risk in carry trades,” says Sarno.

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