Discussion Paper Details

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Title: Carry Trades and Global Foreign Exchange Volatility

Author(s): Lukas Menkhoff, Lucio Sarno, Maik Schmeling and Andreas Schrimpf

Publication Date: March 2011

Keyword(s): carry trade, forward premium puzzle, liquidity and volatility

Programme Area(s): Financial Economics and International Macroeconomics

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 FX volatility risk captures more than 90% of the cross-sectional excess returns in five carry trade portfolios. In turn, these results provide evidence that there is an economically meaningful risk-return relation in the FX market. Further analysis shows that liquidity risk also matters for expected FX returns, but to a lesser degree than volatility risk. Finally, exposure to our volatility risk proxy also performs well for pricing returns of other cross sections in foreign exchange, U.S. equity, and corporate bond markets.

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Bibliographic Reference

Menkhoff, L, Sarno, L, Schmeling, M and Schrimpf, A. 2011. 'Carry Trades and Global Foreign Exchange Volatility'. London, Centre for Economic Policy Research.