Risk and Return of Conditional Currency Carry Trades

Traditionally, currency carry trade (CT) strategies try to exploit currency mispricing by borrowing in low-interest rate currencies and investing in high-interest rate currencies. These CT strategies are profitable on average because uncovered interest rate parity (UIP) does not hold in general. This implies that conditional CT strategies, that exclude regimes from the investment opportunity set for which UIP holds, should outperform the standard, unconditional CT strategies. In this paper we propose an easy-to-implement conditional CT strategy that excludes regimes for which UIP is likely to hold, namely when interest rate differentials (IRDs) are very large and foreign exchange (FX) volatility is high. We condition our CT strategy by excluding the extreme positive IRDs during periods of high FX volatility from the investment opportunity set. We also consider the impact of conditioning on high FX volatility only, and on very large IRDs only. We find that conditioning a CT strategy on both FX volatility and on extreme IRDs outperforms the base-case in terms of mean return, holding period return, and Sharpe ratio in virtually any of the settings analysed.

The Brown Bag Seminars are sponsored by ERIM.
www.eur.nl/financegroup