Are Carry Trade Risks Systematic Risks Now? An Analysis of the Dynamics of Carry Trade Risks

Abstract

In this paper, I study individual currency pairs and examine the behavior of the cross section of their carry returns with the USD. Developed and emerging market carry trades yield high Sharpe ratios even after adjusting for transaction costs. I show that carry trade risks carry trade risks are dynamic and have become more systematic in recent years. From 1999 onwards, the high carry return currencies have significant coefficients in a time series regression of returns on the US stock market returns, implied volatility innovations of the US stock market options (VIX), TED spreads. In addition to the time series factor loadings, I find that the cross section of carry trade returns can be sorted by betas on the any of these variables - US stock market, VIX innovations and TED spreads. I also document the increasing role of inflation growth in the cross section of currency returns and the increase in carry returns due to the presence of differentially inflation targeting central banks. I find that in both periods, the more negatively a central banks Taylor rule beta with respect to the US central bank is, the higher the return that currency pair achieves. I analyze how this observation may help make hedge funds and investors investing in other countries endogenous in theoretical models.