Carry Trades and Global FX Volatility

Menkhoff, Lukas and Sarno, Lucio and Schmeling, Maik and Schrimpf, Andreas (2009): Carry Trades and Global FX Volatility.

Abstract

We investigate the relation between global FX volatility and the excess returns to carry trade portfolios. We find a significantly negative return co-movement of high interest rate currencies with global volatility, whereas low interest rate currencies provide a hedge against volatility shocks. Our main global FX volatility proxy accounts for more than 90% of the return spread in five carry trade portfolios. Further analyses show that: (i) liquidity risk also matters for excess returns, but to a lesser degree; and that (ii) excess returns are more strongly related to unexpected components of volatility than to expected components. Our results are robust to different proxies for volatility risk, and extend to other cross-sections such as individual currency returns and (some) momentum portfolios.

• Item Type: MPRA Paper
• Language: English
• Keywords: Carry Trade, Volatility, Liquidity, Forward Premium Puzzle
• Subjects: G - Financial Economics > G1 - General Financial Markets > G12 - Asset Pricing ; Trading Volume ; Bond Interest Rates; G - Financial Economics > G1 - General Financial Markets > G15 - International Financial Markets; F - International Economics > F3 - International Finance > F31 - Foreign Exchange

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