Common Information in Carry Trade Risk Factors

Byrne, Joseph P and Ibrahim, Boulis Maher and Sakemoto, Ryuta (2016): Common Information in Carry Trade Risk Factors.

Abstract

Carry returns have been widely observed in the FX market. This study exploits the common information embedded in several factors previously identified as relevant to carry trade returns. We find that the extracted common factor successfully models the time series and cross-sectional characteristics of carry returns. Empirical evidence is presented that the common factor produces smaller pricing errors than other well known factors, such as innovations of exchange rate volatility and the downside stock market excess return. Our results also suggest that stock market risk is somewhat segmented from FX market risk.

• Item Type: MPRA Paper
• Language: English
• Keywords: Currency Carry Trade, Risk Factor, Principal Components, Fama-MacBeth
• Subjects: C - Mathematical and Quantitative Methods > C3 - Multiple or Simultaneous Equation Models ; Multiple Variables > C38 - Classification Methods ; Cluster Analysis ; Principal Components ; Factor Models; F - International Economics > F3 - International Finance > F31 - Foreign Exchange; 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

References

Ahmed, S., and Valente, G. (2015). Understanding the price of volatility risk in carry trades. Journal of Banking and Finance, 57, 118-129.

Andrews, D. (1991). Heteroskedasticity and autocorrelation consistent covariance matrix estimation. Econometrica, 59, 817-858.

Ang, A., Liu, J., and Schwarz, K. (2010). Using stocks or portfolios in tests of factor models. Working paper, Columbia University.

Atanasov, V. and Nitschka, T. (2014). Currency excess returns and global downside market risk. Journal of International Money and Finance, 47, 268-285.

Brunnermeier, M., Nagel, S., and Pedersen, L. (2009). Carry trades and currency crashes. in: D. Acemoglu, K. Rogoff, and M. Woodford. (Eds.), NBER Macroeconomics Annual 2008, National Bureau of Economic Research, Massachusetts Avenue Cambridge, 313 - 347.

Brandt, M. W., Cochrane, J. H., and Santa-Clara, P. (2006). International risk sharing is better than you think, or exchange rates are too smooth. Journal of Monetary Economics, 53, 671-698.

Burnside C. (2011). The cross-section of foreign currency risk premia and consumption growth risk: Comment. American Economic Review, 101, 3456-3476.

Burnside C., Eichenbaum, M., Kleshchelski I., and Rebelo, S. (2011). Do Peso problems explains in the returns to the carry trade? Review of Financial Studies, 24, 853-891.

Christiansen, C., Ranaldo, A., and Soderlind, P. (2011). The time-varying systematic risk of carry trade strategies. Journal of Financial and Quantitative Analysis, 46, 1107-1125.

Copeland, L. and Lu, W. (2016). Dodging the steamroller: Fundamentals versus the carry trade. Journal of International Financial Markets, Institutions and Money, 42, 115-131.

Darvas, Z. (2009). Leveraged carry trade portfolios. Journal of Banking and Finance, 33, 944-957.

Das, S., Kadapakkam, P-R., and Yiuman, T. (2013). Is carry-trade a viable alternative asset class? Journal of International Financial Markets, Institutions and Money, 24, 247-257.

Dobrynskaya, V. (2014). Downside market risk of carry trades. Review of Finance, 18, 1885-1913.

dos Santos, M. B. C., Klotzle, M. C., and Pinto, A. C. F. (2016). Evidence of risk premiums in emerging market carry trade currencies. Journal of International Financial Markets, Institutions and Money, in press.

Engel, C. (1996). The forward discount anomaly and the risk premium: A survey of recent evidence Journal of Empirical Finance, 3, 123-192.

Engel, C., Mark, N. C., and West, K. D. (2015). Factor Model Forecasts of Exchange Rates Econometrics Review, 34, 32-55.

Engle, R F. and Lee, G. G. J. (1999). A long-run and short-run component model of stock return volatility. in: R. F. Engle and H. White. (Eds.), Cointegration, Causality, and Forecasting: A Festschrift in Honour of Clive W.J. Granger, Oxford University Press, New York, 381-441.

Fama, E. F. (1984). Forward and spot exchange rate. Journal of Monetary Economics, 14, 319-338.

Fama, E. F. and MacBeth, J. D. (1973). Risk, return, and equilibrium: Empirical tests. Journal of Political Economy, 81, 607-636.

Farhi, E. and Gabaix, X. (2016). Rare disaster and exchange rates Quarterly Journal of Economics, 131, 1-52.

Giglio, S., Kelly, B., and Pruitt, S. (2016). Systemic risk and the macroeconomy: An empirical evaluation. Journal of Financial Economics, 119, 457-471.

Kan, R., Robotti, C., and Shanken J. (2013). Pricing model performance and the two-pass cross-sectional regression methodology. Journal of Finance, 68, 2617-2649.

Lettau, M., Maggiori, M., and Weber, M. (2014). Conditional risk premia in currency markets and other asset classes. Journal of Financial Economics, 114, 197-225.

Lewellen, J., Nagel, S., and Shanken, J. (2010). A skeptical appraisal of asset pricing test. Journal of Financial Economics, 96, 175-194.

Lewis, K. K. (1995). Puzzles in international financial markets. in: G. M. Grossman and K. Rogoff. (Eds.), Handbook of International Economics, vol.3, North Holland, Amsterdam, 1913-1971.

Lo A. W. and MacKinlay, C. A. (1990). Data-snooping biases in tests of financial asset pricing models. Review of Financial Studies, 3, 431-467.

Ludvigson, S. C., and Ng, S. (2009). Macro factors in bond risk premia. Review of Financial Studies, 22, 5027-5067.

Lustig, H., Roussanov, N., and Verdelhan, A. (2011). Common risk factors in currency markets. Review of Financial Studies, 24, 3731-3777.

Lustig, H. and Verdelhan, A. (2007). The cross-section of foreign currency risk premia and consumption growth risk. American Economic Review, 97, 89-117.

Menkhoff, L., Sarno, L., Schmeling, M. and Schrimpf, A. (2012a). Carry trades and global foreign exchange volatility. Journal of Finance, 67, 681-718.

Menkhoff, L., Sarno, L., Schmeling, M. and Schrimpf, A. (2012b). Currency momentum strategies. Journal of Financial Economics, 106, 660-684.

Newey, W. K. and West, K. D. (1987). A simple, positive semi-definite, heteroskedasticity and autocorrelation consistent covariance matrix. Econometrica, 55, 703-708.

Orlov. (2016). Currency momentum, carry trades, and market liquidity. Journal of Banking and Finance, 67, 1-11.

Rafferty, B. (2011). Currency returns, skewness and crash risk. Working Paper, Duke University.

Shanken, J. (1992). On the estimation of beta-pricing models. Review of Financial Studies, 5, 1-33.