Swedroe: Carry Trade Caveats

November 09, 2018

Martin Lettau, Matteo Maggiori and Michael Weber, authors of the 2014 study “Conditional Risk Premia in Currency Markets and Other Asset Classes,” also provide 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.”

Pasquale Della Corte, Steven Riddiough and Lucio Sarno, authors of the study “Currency Premia and Global Imbalances,” which covered a broad sample of 55 currencies and a subsample of 15 developed-market currencies for the period October 1983 through June 2014, provided empirical evidence that exposure to countries’ external imbalances (trade and capital accounts) is a key component to understanding currency risk premiums—countries run trade imbalances and financiers absorb the resultant currency risk. In other words, financiers are long the debtor country and short the creditor country.

The authors’ hypothesis was that currency excess returns are higher when the funding (investment) country is a net foreign creditor (debtor) and has a higher propensity to issue liabilities denominated in domestic (foreign) currency. The relationship between currency excess returns and net foreign assets captures the link between external imbalances and currency risk premiums.

Currency Risk-Premium Drivers

Della Corte, Riddiough and Sarno also found the currency denomination of external debt matters for currency risk premiums. Countries that cannot issue debt in their own currency are riskier. Thus, currency risk premiums are driven by the evolution and currency denomination of net foreign assets.

Specifically, in the presence of a financial disruption (i.e., risk-bearing capacity is low and global risk aversion is high), net-debtor countries experience a currency depreciation, unlike net-creditor countries.

This risk generates currency risk premiums: Investors demand a risk premium for holding net-debtor countries’ currencies because these currencies perform poorly in bad times, which are times of large shocks to global risk aversion.

Specifically, they found that a currency strategy that buys the extreme net-debtor countries with the highest propensity to issue external liabilities in foreign currency and sells the extreme creditor countries with the lowest propensity to issue liabilities in foreign currency (a global imbalance strategy) generates Sharpe ratios of 0.59 for a universe of major countries and 0.68 for the broader set of 55 countries. The excess return is greater than 5% per year.

The authors concluded: “Returns to carry trades are compensation for time-varying fundamental risk, and thus carry traders can be viewed as taking on global imbalance risk.” They add: “Global imbalances are a key driver of currency risk premia: net debtor currencies are predicted to warrant an excess currency return in equilibrium and to depreciate at times when risk-bearing capacity falls.”

Latest Research

Regina Hammerschmid and Alexandra Janssen provide the latest contribution to the literature on the currency carry trade with their September 2018 study “Crash-o-phobia in Currency Carry Trade Returns.

They noted that, historically, currency carry trade returns display both high downside market risk and high crash risk (the presence of rare disasters such as the “peso problem”). These are risks for which investors should be compensated. And because investors tend to be risk averse, assets that perform badly in bad times should have large risk premiums. Their data sample, restricted by the availability of currency options prices, covers the period October 2003 through June 2016.

Following is a summary of their findings, which are consistent with the theory of investor risk aversion first proposed by Amos Tversky and Daniel Kahneman in their famous paper “Advances in Prospect Theory: Cumulative Representation of Uncertainty.” The findings are also consistent with the prior research cited above.

  • Currency carry trade returns are on average large and non-normally distributed.
  • Investor loss aversion and overweighting of low probability events (crash-o-phobia) explains the carry premium.

There’s one other study we need to cover that provides evidence investors should consider before adding a currency carry trade allocation to their portfolio. Klaus Grobys and Jari-Pekka Heinonen, authors of the study “Is There a Credit Risk Anomaly in FX Markets?” which was published in the August 2016 issue of Finance Research Letters, examined whether a link exists between sovereign credit ratings and currency returns. The availability of credit rating data dictated the sample period, which was the relatively short time frame from January 1998 through December 2010.

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