Dynamic Risk Factors in Carry Trades

Abstract

The authors decompose a simple cross-country interest rate differential into three cross-country differential factors, originated from the Nelson–Siegel model. Results suggest that return premiums for carry trades are highly associated with parallel yield curve shifts in investment currencies against the US yield curve. Currency portfolios based on cross-country yield curve gap can be profitable, with lowest tercile portfolios yielding sizable risk-adjusted returns adjusted for transaction costs. The authors’ model identifies higher currency carry returns for hedge funds when cross-country yield curves exhibit a wide interest gap over all maturities and finds that investment currency yields have greater curvature relative to funding currency yields. TOPICS: Currency, performance measurement, global markets