Academic journal article Federal Reserve Bank of Atlanta, Working Paper Series

Foreign Exchange Predictability during the Financial Crisis: Implications for Carry Trade Profitability

Academic journal article Federal Reserve Bank of Atlanta, Working Paper Series

Foreign Exchange Predictability during the Financial Crisis: Implications for Carry Trade Profitability

Article excerpt

1 Introduction

Modern international macroeconomia theory is founded on the belief that exchange rates are inherently predictable using economic fundamentals. Nonetheless, the empirical evidence is largely inconclusive or even completely unsupportive of this view. A large literature, starting with Meese and Rogoff (1983), has documented the empirical regularity that the random walk model of exchange rates is the best performing model in terms of out-of-sample forecasting. While a near-random-walk behavior in exchange rates is expected when the discount factor is near unity (Engel and West, 2005), the failure of the economic fundamentals and financial variables to exhibit any systematic predictive power is widely regarded as a major weakness of the modern international macroeconomics (Bacchetta and van Wincoop, 2006). (1) The absence of empirical evidence in support of exchange rate predictability, however, should not be construed as evidence of absence of predictability. In fact, exchange rate predictability may not have been detected due to possible hidden nonlinearities or slow-moving latent state variables whose effect passes undetected through the currency markets. (2)

The most significant departure from the lack of predictability of exchange rates has been documented in the carry trade literature. In a carry trade, an investor borrows in a low-interest currency and invests the borrowed funds in a high-yielding currency. (3) Under risk neutrality and uncovered interest rate parity (UIP), the carry trade should yield a zero average return. Despite the theoretical predictions, the carry trade has remained popular among investors and this led to widespread academic interest in the strategy's profitability. (4) The consensus emerging from the empirical research suggests that the carry trade has provided investors with statistically and economically significant positive returns over sustained periods. The documented profitability of the carry trade is consistent with the lack of empirical support for the UIP and with the voluminous literature on the forward premium puzzle (see Engel, 2015a, for a recent review of this literature).

A number of possible explanations have been advanced to account for the positive average returns of carry trade. In a classical asset pricing context, the positive average returns should reflect compensation for bearing a (possibly time-varying) risk premium and a number of recent contributions to the literature thoroughly examine the performance of common risk factors in currency pricing models (Lustig, Roussanov and Verdelhan, 2011; Burnside, Eichenbaum and Rebelo, 2011, Burnside, 2012). The findings emerging from these studies suggest that, with the exception of a global volatility risk factor, the TED spread (Bakshi and Panayotov, 2013), and term structure of interest rate variables (Ang and Chen, 2010; Lustig, Stathopoulos and Verdelhan, 2015), conventional equity and fixed-income market risk factors have demonstrated limited success in explaining the returns to the carry trade. In contrast, observable currency-specific risk factors, commonly used to assign individual currencies into portfolios, have shown more promise in predicting carry trade returns (Bakshi and Panayotov, 2013; Lustig, Roussanov and Verdelhan, 2011; Menkhoff, Sarno, Schmeling, and Schrimpf, 2012b).

Another strand of the literature underscores the fact that positive carry trade returns are occasionally followed by large crash losses (Brunnermeier, Nagel and Pedersen, 2009; Berge, Jorda and Taylor, 2010; Farhi, Fraiberger, Gabaix, Ranciere and Verdelhan, 2009; Jorda and Taylor, 2012) and entertains the importance of peso effects in driving the strategy's profitability (Burnside, Eichenbaum, Kleshchelski and Rebelo, 2011; Burnside, 2012). The existence of crash returns and peso problems possibly reconciles the profitability of the carry trade with the predictions of UIP. A parallel literature investigates the importance of 'limits to arbitrage and hedging' in explaining the carry trade's profitability. …

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