Carry On

Abstract

The carry trade in foreign currencies is known for delivering positive returns, on average, and for occasionally suffering large losses. While these characteristics prevail, on average, across time and across currency pairs, the authors find that interest rate differentials on their own are not sufficient to identify conditions in which currencies reliably exhibit these return and risk attributes. They use three variables—valuation, crowding, and volatility—to identify time periods and cross-sections of currencies in which the carry trade performs best. They document a substantial difference in performance between the carry trade applied to high-volatility versus low-volatility currency pairs. In the full sample from 1984 to 2017, carry in high-volatility pairs has consisted of currencies that are undervalued, on average, experience greater swings in valuation, and have boom and bust cycles aligned with investor crowding. This finding is consistent with the notion that carry represents a risk premium. Carry in low-volatility pairs has the opposite characteristics. Though both strategies performed well prior to the 2008 financial crisis, only carry in high-volatility pairs has worked since. TOPICS: Currency, quantitative methods, analysis of individual factors/risk premia