The Forward Premium Bias, Carry Trade Return and the Risks of Volatility and Liquidity

Shehadeh, Ali and Li, Youwei and Moore, Michael (2016): The Forward Premium Bias, Carry Trade Return and the Risks of Volatility and Liquidity.

Abstract

In this paper, we analyse the relationship between the currency carry return and volatility and liquidity risk factors. We find that both categories of risk factors are relevant to understanding and explaining carry return, with an outperformance for volatility ones especially the global FX volatility risk factor. Consistent with the poor performance of currency carry trades during high FX volatility regime, we also show that the well-established negative slope coefficient in the Fama regression tends to be more positive and even above unity in times of high FX volatility. The paper, overall, contributes to the risk-based solution of the forward premium bias puzzle.

• Item Type: MPRA Paper
• Language: English
• Keywords: FX rates; Currency carry trade; Forward-bias puzzle; FX risk premium
• Subjects: E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E44 - Financial Markets and the Macroeconomy; F - International Economics > F3 - International Finance > F31 - Foreign Exchange; F - International Economics > F4 - Macroeconomic Aspects of International Trade and Finance > F41 - Open Economy Macroeconomics; G - Financial Economics > G1 - General Financial Markets > G11 - Portfolio Choice ; Investment Decisions; G - Financial Economics > G1 - General Financial Markets > G15 - International Financial Markets

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