Predictability of currency carry trades and asset pricing implications

Exchange rate models with uncertain and incomplete information predict that investors focus on a small set of fundamentals that changes frequently over time. We design a model selection rule that captures the current set of fundamentals that best predicts the exchange rate. Out-of-sample tests show that the forecasts made by this rule significantly beat a random walk for 5 out of 10 currencies. Furthermore, the currency forecasts generate meaningful investment profits. We demonstrate that the strong performance of the model selection rule is driven by time-varying weights attached to a small set of fundamentals, in line with theory.

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“…Bakshi and Panayotov (2013) show that carry-trade returns can be predicted with changes in volatility, commodity prices, and a liquidity factor.…”

Section: Time-varying Fundamentalsmentioning

confidence: 97%

Model Uncertainty and Exchange Rate Forecasting

Kouwenberg¹,

Markiewicz²,

Verhoeks³

et al. 2017

J. Financ. Quant. Anal.

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“…As a point of comparison, our analysis takes into consideration other factors in the literature, such as the Bakshi and Panayotov (2013) predictors or average forward discounts in order to estimate conditional predictive regressions of the common factors. We find that our factors can forecast currency excess returns over and above commodity, volatility, and liquidity factors as well as average forward discounts.…”

Section: Introductionmentioning

confidence: 99%

Common Macro Factors and Currency Premia

Filippou¹,

Taylor²

2017

J. Financ. Quant. Anal.

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We study the role of domestic and global factors on payoffs of portfolios mimicking carry, dollar carry and momentum strategies. Using factors summarizing large datasets of macroeconomic and financial variables, we find that global equity market factors are predictive for carry trade returns, while U.S. inflation and consumption variables drive dollar carry trade payoffs, momentum returns are predominantly driven by U.S. inflation factors, and global factors capture the countercyclical nature of currency premia. We also find predictability in the exchange rate component of each strategy and demonstrate strong economic value to risk-averse investors with mean-variance preferences, regardless of base currency.

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“…Empirically, I focus on the one-month carry trade returns which are computed using the practical version of (41) As reported by Bakshi and Panayotov (2011), carry trade is more profitable when implemented on a dynamic re-balancing basis, under which investors always short the low-interest currency and long the high-interest currency. Correspondingly on the model side, I need to break the complete symmetry so as to produce positive expected returns for carry trade.…”

Section: The First Two Moments Of Carry Trade Returnsmentioning

confidence: 99%

“…Different from Verdelhan (2010), and Bansal and Shaliastovich (2010) who respectively apply habit formation and long-run risk to explain the UIP anomaly, this paper exploits a variable disaster framework. Departing from Burnside, Eichenbaum, Kleshchelski, andRebelo (2011), andPanayotov (2011), it provides a general equilibrium setup for studying carry trade. Unlike 1 Take the UIP anomaly for example.…”

Section: Introductionmentioning

confidence: 99%

General equilibrium pricing of currency and currency options

Du¹

2013

Journal of Financial Economics

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This paper presents a consumption-based general equilibrium model for valuing foreign exchange contingent claims. The model identifies a novel economic mechanism by exploiting highly but imperfectly shared consumption disaster with variable intensities which are the concerns to the representative investor under recursive utility. When applied to the data, the model simultaneously replicates i) the moderate option-implied volatilities; ii) substantial variations in the risk-neutral skewness of currency returns; iii) the uncovered interest rate parity puzzle; and iv) the first two moments of carry trade returns. Furthermore, the model rationalizes salient features of the aggregate stock, government bonds, and equity index options.JEL code: F31, G01, G11

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Predictability of currency carry trades and asset pricing implications

Cited by 130 publications

References 74 publications

Model Uncertainty and Exchange Rate Forecasting

Model Uncertainty and Exchange Rate Forecasting

Common Macro Factors and Currency Premia

General equilibrium pricing of currency and currency options

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