The pricing of risk in the carry trade

Lu, Wenna 2014. The pricing of risk in the carry trade. PhD Thesis, Cardiff University. Item availability restricted.

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Abstract

ABSTRACT This thesis examines the relationship between foreign exchange (FX) volatility and excess returns from the currency market. We argue that FX volatility plays an important role in explaining the excess returns from the currency market so as in partially explaining the long stranding unsolved puzzles in FX market: the uncovered interest rate parity (UIP) puzzle and the purchasing power parity (PPP) puzzle. There are two empirical parts in this thesis. In the first part, we take the FX volatility risk as risk factors to price the cross sectional excess returns from the carry trade in three different settings, the unconditional ICAPM model, the conditional ICAPM model and a model separating the volatility risk into a persistent volatility risk factor and a less persistent volatility risk factor. For all three models, we find that the excess returns from the carry trade are negatively correlated with the FX volatility risk factors. The volatility risk factors are negatively priced and can explain about 90% cross sectional excess returns from the carry trade. We argue that the excess returns from the carry trade are compensations for bearing volatility risks, especially during high volatility risk period and regardless whether the volatility risks are persistent or not. In the second part, we investigate the puzzles in FX market under different FX volatility regimes. We find that the carry trade suffers from losses during high volatility period is because both the UIP and the PPP tends to reassert themselves under high volatility period, at least to some extent. Thus if we switch from the carry trade strategy to a PPP implied trading strategy during high volatility period, we could avoid the losses from the carry trade and have higher average excess returns. More importantly, we could make this “mixed” strategy tradable by using last period’s FX volatility state to forecast this period’s volatility state.

Item Type:	Thesis (PhD)
Status:	Unpublished
Schools:	Business (Including Economics)
Subjects:	H Social Sciences > HB Economic Theory
Funders:	Funding Bursary Fees only Sir Julian Hodge
Last Modified:	19 Oct 2023 12:54
URI:	https://orca.cardiff.ac.uk/id/eprint/61773

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