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

By Anatolyev, Stanislav; Gospodinov, Nikolay et al. | Federal Reserve Bank of Atlanta, Working Paper Series, August 1, 2015 | Go to article overview

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


Anatolyev, Stanislav, Gospodinov, Nikolay, Jamali, Ibrahim, Liu, Xiaochun, Federal Reserve Bank of Atlanta, Working Paper Series


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. …

The rest of this article is only available to active members of Questia

Already a member? Log in now.

Notes for this article

Add a new note
If you are trying to select text to create highlights or citations, remember that you must now click or tap on the first word, and then click or tap on the last word.
One moment ...
Default project is now your active project.
Project items
Notes
Cite this article

Cited article

Style
Citations are available only to our active members.
Buy instant access to cite pages or passages in MLA 8, MLA 7, APA and Chicago citation styles.

(Einhorn, 1992, p. 25)

(Einhorn 25)

(Einhorn 25)

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Note: primary sources have slightly different requirements for citation. Please see these guidelines for more information.

Cited article

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

Settings

Typeface
Text size Smaller Larger Reset View mode
Search within

Search within this article

Look up

Look up a word

  • Dictionary
  • Thesaurus
Please submit a word or phrase above.
Print this page

Print this page

Why can't I print more than one page at a time?

Help
Full screen
Items saved from this article
  • Highlights & Notes
  • Citations
Some of your highlights are legacy items.

Highlights saved before July 30, 2012 will not be displayed on their respective source pages.

You can easily re-create the highlights by opening the book page or article, selecting the text, and clicking “Highlight.”

matching results for page

    Questia reader help

    How to highlight and cite specific passages

    1. Click or tap the first word you want to select.
    2. Click or tap the last word you want to select, and you’ll see everything in between get selected.
    3. You’ll then get a menu of options like creating a highlight or a citation from that passage of text.

    OK, got it!

    Cited passage

    Style
    Citations are available only to our active members.
    Buy instant access to cite pages or passages in MLA 8, MLA 7, APA and Chicago citation styles.

    "Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn, 1992, p. 25).

    "Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn 25)

    "Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn 25)

    "Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences."1

    1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

    Cited passage

    Thanks for trying Questia!

    Please continue trying out our research tools, but please note, full functionality is available only to our active members.

    Your work will be lost once you leave this Web page.

    Buy instant access to save your work.

    Already a member? Log in now.

    Search by... Author
    Show... All Results Primary Sources Peer-reviewed

    Oops!

    An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.