The authors divided a sample of 39 currencies into three portfolios by sorting on the previous month’s Oxford Economics sovereign credit rating. Portfolios were formed by going long the one-third of currencies with the lowest credit rating and short the one-third of currencies with the highest credit rating. Following is a summary of their surprising findings:
- While premiums were found for the carry trade, volatility and momentum, there was a negative premium of 0.30% per month for the credit strategy. And importantly, the data was statistically significant at the 1% level.
- Average portfolio returns sorted by credit risk decrease linearly as they move from the low-credit-risk portfolio to the high-credit-risk portfolio. This suggests higher credit risk is associated with lower returns. In addition to negative returns, the long low-credit-quality and short high-credit-quality portfolio has a non-normal distribution. There is negative skewness (-0.5) and excess kurtosis (2.9), or a fat tail.
The authors concluded: “Even though risk-based asset pricing theory suggests that riskier assets should generate higher payoffs than less risky assets, our results suggest that currencies of countries with a high credit risk tend to generate lower returns than currencies of less risky countries.”
An important portfolio implication is that investors should account for credit risk when implementing a carry strategy. For example, investors can pursue carry only in the currencies of countries with high-quality sovereign debt, or avoid going long low-quality sovereign debt.
The academic literature shows that investments in high-interest currencies deliver large
positive returns. However, the distribution of returns is negatively skewed, exhibits fat tails and crashes occasionally due to rare events, or systematically along with the stock market.
The evidence is persistent across long periods of time, pervasive across asset classes, is implementable and has intuitive risk-based explanations, as the large premium associated with the carry trade is well explained by linkages between exchange rate returns and macroeconomic fluctuations.
Thus, we have fundamental and theoretically motivated sources of risk driving currency returns. These explanations also provide a logical resolution to the UIP puzzle.
At Buckingham Strategic Wealth, we access the carry trade in a diversified way (across stocks, bonds, commodities and currencies)—which greatly reduces the crash risk—through investments in AQR’s Style Premia Alternative Fund (QSPRX) and Alternative Risk Premia Fund (QRPRX).
These funds provide exposure to multiple factors across multiple asset classes. QSPRX provides exposure to factors of value, cross-sectional momentum, carry and defensive across stocks, bonds, commodities and currencies. QRPRX provides exposure to the same four factors plus time-series momentum and the equity variance premium across stocks, bonds and currencies. (Full disclosure: My firm, Buckingham Strategic Wealth, recommends AQR funds in constructing client portfolios.)
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.