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The Time-Varying Systematic Risk of Carry Trade Strategies

Published online by Cambridge University Press:  16 May 2011

Charlotte Christiansen ,
Angelo Ranaldo  and
Paul Söderlind
Charlotte Christiansen
Affiliation:
School of Economics and Management, Aarhus University, Bartholins Alle 10, 8000, cchristiansen@creates.au.dk
Angelo Ranaldo
Affiliation:
Research Department, Swiss National Bank, Börsenstrasse 15, 8022, angelo.ranaldo@snb.ch
Paul Söderlind
Affiliation:
Swiss Institute for Banking and Finance, University of St. Gallen, Rosenbergstr. 52, 9000, paul.soderlind@unisg.ch
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Abstract

We explain the currency carry trade (CT) performance using an asset pricing model in which factor loadings are regime dependent rather than constant. Empirical results show that a typical CT strategy has much higher exposure to the stock market and is mean reverting in regimes of high foreign exchange volatility. The findings are robust to various extensions. Our regime-dependent pricing model provides significantly smaller pricing errors than a traditional model. Thus, the CT performance is better explained by a time-varying systematic risk that increases in volatile markets, suggesting a partial resolution of the uncovered interest parity puzzle.

Type
Research Articles
Information
Journal of Financial and Quantitative Analysis , Volume 46 , Issue 4 , August 2011 , pp. 1107 - 1125
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2011

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