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Carry Trades and Global Foreign Exchange Volatility
Author(s) -
MENKHOFF LUKAS,
SARNO LUCIO,
SCHMELING MAIK,
SCHRIMPF ANDREAS
Publication year - 2012
Publication title -
the journal of finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 18.151
H-Index - 299
eISSN - 1540-6261
pISSN - 0022-1082
DOI - 10.1111/j.1540-6261.2012.01728.x
Subject(s) - volatility (finance) , economics , volatility risk premium , volatility risk , foreign exchange , monetary economics , interest rate , hedge , implied volatility , volatility swap , proxy (statistics) , financial economics , volatility smile , market liquidity , econometrics , mathematics , ecology , statistics , biology
ABSTRACT We investigate the relation between global foreign exchange (FX) volatility risk and the cross section of excess returns arising from popular strategies that borrow in low interest rate currencies and invest in high interest rate currencies, so‐called “carry trades.” We find that high interest rate currencies are negatively related to innovations in global FX volatility, and thus deliver low returns in times of unexpected high volatility, when low interest rate currencies provide a hedge by yielding positive returns. Furthermore, we show that volatility risk dominates liquidity risk and our volatility risk proxy also performs well for pricing returns of other portfolios.