Post by Menkhoff on Feb 16, 2010 8:04:32 GMT 4
Carry Trades and Global Foreign Exchange Volatility
Lukas Menkhoff
Leibniz Universitaet Hannover - Department of Economics; CESifo (Center for Economic Studies and Ifo Institute for Economic Research)
Lucio Sarno
Cass Business School; Centre for Economic Policy Research (CEPR)
Maik Schmeling
Leibniz Universität Hannover - Department of Economics
Andreas Schrimpf
CREATES - Aarhus University
February 5, 2010
EFA 2009 Bergen Meetings Paper
Abstract:
We investigate the relation between global foreign exchange (FX) volatility risk and the cross-section of excess returns arising from popular strategies that borrow in low-interest rate currencies and invest in high-interest rate currencies, so-called 'carry trades'. We find that high interest rate currencies are negatively related to innovations in global FX volatility and thus deliver low returns in times of unexpected high volatility, when low interest rate currencies provide a hedge by yielding positive returns. Our proxy for global foreign exchange volatility risk captures more than 90% of the cross-sectional excess returns in five carry trade portfolios. Further analysis shows that liquidity risk also matters for expected FX returns, but to a lesser degree than volatility risk, and that our volatility risk proxy also prices other cross sections of assets returns, such as option portfolios, bond portfolios, and individual currency returns. In turn, these results provide evidence that there is an economically meaningful risk-return relation in the foreign exchange market.
papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1548348_code364821.pdf?abstractid=1342968&mirid=2
Lukas Menkhoff
Leibniz Universitaet Hannover - Department of Economics; CESifo (Center for Economic Studies and Ifo Institute for Economic Research)
Lucio Sarno
Cass Business School; Centre for Economic Policy Research (CEPR)
Maik Schmeling
Leibniz Universität Hannover - Department of Economics
Andreas Schrimpf
CREATES - Aarhus University
February 5, 2010
EFA 2009 Bergen Meetings Paper
Abstract:
We investigate the relation between global foreign exchange (FX) volatility risk and the cross-section of excess returns arising from popular strategies that borrow in low-interest rate currencies and invest in high-interest rate currencies, so-called 'carry trades'. We find that high interest rate currencies are negatively related to innovations in global FX volatility and thus deliver low returns in times of unexpected high volatility, when low interest rate currencies provide a hedge by yielding positive returns. Our proxy for global foreign exchange volatility risk captures more than 90% of the cross-sectional excess returns in five carry trade portfolios. Further analysis shows that liquidity risk also matters for expected FX returns, but to a lesser degree than volatility risk, and that our volatility risk proxy also prices other cross sections of assets returns, such as option portfolios, bond portfolios, and individual currency returns. In turn, these results provide evidence that there is an economically meaningful risk-return relation in the foreign exchange market.
papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1548348_code364821.pdf?abstractid=1342968&mirid=2