Carry Trades and Global Foreign Exchange Volatility

TLDR

The study investigates how global foreign exchange volatility risk relates to excess returns from carry‑trade strategies that borrow in low‑rate currencies and invest in high‑rate currencies. The authors analyze the cross‑section of carry‑trade excess returns in relation to global FX volatility risk. High‑interest currencies underperform during spikes in global FX volatility, while low‑interest currencies hedge and yield positive returns, and a volatility‑risk proxy explains over 90% of carry‑trade excess returns, indicating a significant risk‑return relationship that also helps price returns in other FX, equity, and bond markets.

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.