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Carry Trades and Global FX Volatility

Author

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  • Menkhoff, Lukas
  • Sarno, Lucio
  • Schmeling, Maik
  • Schrimpf, Andreas

Abstract

We investigate the relation between global FX volatility and the excess returns to carry trade portfolios. We find a significantly negative return co-movement of high interest rate currencies with global volatility, whereas low interest rate currencies provide a hedge against volatility shocks. Our main global FX volatility proxy accounts for more than 90% of the return spread in five carry trade portfolios. Further analyses show that: (i) liquidity risk also matters for excess returns, but to a lesser degree; and that (ii) excess returns are more strongly related to unexpected components of volatility than to expected components. Our results are robust to different proxies for volatility risk, and extend to other cross-sections such as individual currency returns and (some) momentum portfolios.

Suggested Citation

  • Menkhoff, Lukas & Sarno, Lucio & Schmeling, Maik & Schrimpf, Andreas, 2009. "Carry Trades and Global FX Volatility," MPRA Paper 14728, University Library of Munich, Germany.
    • Handle: RePEc:pra:mprapa:14728
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    Cited by:

    1. Carol Osler, 2012. "Market Microstructure and the Profitability of Currency Trading," Working Papers 48, Brandeis University, Department of Economics and International Business School.
    2. Baillie, Richard T. & Chang, Sanders S., 2011. "Carry trades, momentum trading and the forward premium anomaly," Journal of Financial Markets, Elsevier, vol. 14(3), pages 441-464, August.
    3. Kevin Ross & Tommaso Mancini Griffoli, 2010. "Discussion: The Swiss Franc Exchange Rate and Deviations from Uncovered Interest Parity: Global vs Domestic Factors," Swiss Journal of Economics and Statistics (SJES), Swiss Society of Economics and Statistics (SSES), vol. 146(I), pages 373-384, March.
    4. Daniel, Kent & Hodrick, Robert J. & Lu, Zhongjin, 2017. "The Carry Trade: Risks and Drawdowns," Critical Finance Review, now publishers, vol. 6(2), pages 211-262, September.

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    More about this item

    Keywords

    Carry Trade; Volatility; Liquidity; Forward Premium Puzzle;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • F31 - International Economics - - International Finance - - - Foreign Exchange

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