Working Paper: CEPR ID: DP8291
Authors: Lukas Menkhoff; Lucio Sarno; Andreas Schrimpf; Maik Schmeling
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.
Keywords: carry trade; forward premium puzzle; liquidity; volatility
JEL Codes: F31; G12; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| High interest rate currencies (F31) | Innovations in global FX volatility (F31) |
| Innovations in global FX volatility (F31) | Carry trade returns (G15) |
| Low interest rate currencies (E43) | Positive returns during high volatility (G17) |
| Liquidity risk (G33) | Expected FX returns (G17) |
| Volatility risk proxy (G17) | Prices returns across asset classes (G19) |