Conditioning Carry Trades: Less Risk, More Return!

Prior studies show that extreme interest rate differentials (IRDs) and high foreign exchange rate (FX) volatility have substantial explanatory power for the validity of UIP. We show that these contemporaneous drivers also have predictive power by implementing a conditional currency carry trade (CT) strategy that excludes regimes for which UIP is likely to hold. Conditioning high FX volatility only, or on both FX volatility and extreme IRDs outperforms the base-case unconditional CT strategy in virtually any of the settings analyzed. Conditioning on very large IRDs only shows mixed findings. Our strategy works best for smaller CT portfolios.