The carry trade may be all the rage, but understanding its risks is essential.
The carry-trade strategy involves borrowing (going short on) a currency with a relatively low interest rate and using the proceeds to purchase (going long on) a currency yielding a higher interest rate, capturing the interest differential. The strategy can be “enhanced” though the use of leverage.
The success of this strategy has led to its proliferation, despite it being at odds with economic theory. Uncovered interest parity (UIP) theory states that there should be an equality of expected returns on otherwise-comparable financial assets denominated in two different currencies.
Thus, according to UIP, we should expect an appreciation of the low-yielding currency by the same amount as the return differential. However, there’s an overwhelming amount of empirical evidence against UIP theory. Thus, we have what is known as the “UIP puzzle.”
Martin Lettau, Matteo Maggiori and Michael Weber—authors of the study “Conditional Risk Premia in Currency Markets and Other Asset Classes,” which appears in the November 2014 issue of the Journal of Financial Economics—provide us with a risk-based explanation for the success of the carry trade. Their study covered the period January 1974 through March 2010 and more than 50 currencies.
The authors found that “while high-yield currencies have higher betas [exposure to equity market risk] than lower-yield currencies, the difference in betas is too small to account for the observed spread in currency returns.”
However, since investors are known to exhibit downside-risk aversion, they extended their research to include a downside risk capital asset pricing model (DR-CAPM). They found that the DR-CAPM does indeed price the cross-section of currency returns.
Specifically, they found that the overall correlation of the carry to trade to beta is 0.14, and that it is statistically significant, with most of the unconditional correlation due to the downstate. Conditional on the downstate, the correlation increases to 0.33, while it’s only 0.03 in the upstate.