DP7345 The Time-Varying Systematic Risk of Carry Trade Strategies

Author(s): Charlotte Christiansen , Angelo Ranaldo , Paul Söderlind

Publication Date: June 2009

Keyword(s): carry trade , factor model , smooth transition regression , time-varying betas

JEL(s): F31 , G11 , G15

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP7345.asp.asp

This paper suggests a factor model for carry trade strategies where the regression coefficients are allowed to depend on market volatility and liquidity. Empirical results on daily data from 1995 to 2008 show that a typical carry trade strategy has much higher exposure to the stock market and also more mean reversion in volatile periods - and that FX market volatility is a priced risk factor. The findings are robust to various extensions, including using more currencies and other proxies for volatility and liquidity (VIX, TED and a bid-ask spread).