Common Idiosyncratic Volatility and Carry Trade Returns

Abstract

I provide new evidence that incomplete consumption risk sharing across countries is an important determinant of carry trade returns. I show that there is a strong co-movement in idiosyncratic volatilities over time, and that shocks to the common idiosyncratic volatility (CIV) factor, defined as the equally weighted average of the idiosyncratic volatilities in the cross-section, are priced. I find that high-interest rate currencies deliver low returns when the CIV increases, which are bad times for investors. Low-interest rate currencies provide a hedge by yielding positive returns. CIV shocks remain an empirically powerful risk factor in explaining the cross-section of carry trade returns after controlling for global foreign exchange (FX) volatility risk. Furthermore, CIV risk is correlated with cross-country income risk faced by households. My findings are consistent with a heterogeneous-agent model with persistent, uninsurable idiosyncratic shocks in consumption growth. The calibrated model quantitatively accounts for the cross-sectional differences in average returns across CIV-beta sorted portfolios for plausible market prices of CIV risk.