Common information in carry trade risk factors

Abstract

Carry returns have been widely observed in the FX market. This study exploits the common information embedded in several factors previously identified as relevant to carry trade returns. We find that the extracted common factor successfully models the time series and cross-sectional characteristics of carry returns. Empirical evidence is presented that the common factor produces smaller pricing errors than other well known factors, such as innovations of exchange rate volatility and the downside stock market excess return. Our results also suggest that stock market risk is somewhat segmented from FX market risk. JEL Classification Codes: C38, F31, G12, G15

Carry Trade Returns and Segmented Risk Pricing

“…This is consistent with the findings of Burnside et al (2011) and Menkhoff et al (2012), where carry-trade portfolio returns appear to be unrelated to traditional risk factors. It also supports the conclusion drawn by Byrne et al (2018) that, based on the larger pricing error of stock market downside risk as compared to a common (carry trade) risk factor, currency and stock markets are not completely integrated, which will be quantified in the next two sections.…”

“…Dobrynskaya (2014) and Lettau et al (2014) explained the cross section of carry-trade returns with an asset pricing model accounting for stock market downside risk. In contrast, Byrne et al (2018) showed that a common (carry-trade) risk factor produces smaller pricing errors compared to foreign exchange volatility and stock market downside risk. They concluded that carry trade portfolios are exposed to risk characteristics not captured by stock market downside risk and, thus, currency and stock markets are not completely integrated.…”

“…Differences in risk pricing between the interest rate market and the stock market would imply that there is no unifying SDF. Thus, (traditional) stock market risk factors may fail to explain carry-trade returns (Burnside, 2011b;Byrne et al, 2018). With real data, one would not assume that risk pricing is equal at every point in time.…”

“…Carry trade strategies show a persistent outperformance compared to a passive benchmark strategy, even on a risk-adjusted basis, and appear to be unrelated to traditional risk factors (Burnside, 2011a;Byrne et al, 2018). Here, investors construct a zeroinvestment portfolio where they borrow funds in low interest rate currencies and invest The original version of this article was revised: The initial online publication contained several typesetting errors.…”

Exploring Carry Trade and Exchange Rate toward Sustainable Financial Resources: An application of the Artificial Intelligence UKF Method

“…Characteristics related to different aspects of carry traders' activities in the foreign exchange market have been considered in many studies [48][49][50]. Based on investment styles, including carry trade, it is shown that carry trade is one of the most important factors that can explain most of the index of returns on professionally managed currency funds [51,52].…”