One of the more popular strategies pursued by hedge funds is the currency carry trade. The strategy involves borrowing (going short) a currency with a relatively low interest rate and then using the proceeds to purchase (going long) a currency yielding a higher interest rate, thus capturing the interest differential. The strategy can be “enhanced” though the use of leverage.
The long-term success of this strategy has led to its proliferation, despite the fact that its superior performance is at odds with economic theory. Uncovered interest parity (UIP) theory suggests that the expected returns on otherwise-comparable financial assets denominated in two different currencies should be equal. So according to UIP, investors should expect an appreciation of the low-yielding currency by the same amount as the return differential.
However, there is overwhelming empirical evidence that contradicts UIP theory. Borrowing in low-interest-rate currencies and investing in high-interest-rate currencies has provided returns of about 5 percent a year, not dissimilar in size to the equity risk premium. Thus, we have what is known as the UIP puzzle.
Research into the carry trade, however, has uncovered a logical solution to the UIP mystery; specifically, that currency returns are related to the systematic risks of stocks and bonds.
Currency Returns And Risks
As Victoria Galsband and Thomas Nitschka, authors of the 2013 article “Foreign- Currency Returns and Systematic Risks,” explain: “Currencies that appreciate when the stock market falls might be a good investment since they provide a valuable insurance against unfavourable fluctuations on equity markets. On the other hand, currencies which depreciate in times of poor stock-market performance tend to further destabilise investors’ positions and should hence offer a premium for their risk.”
The empirical evidence presented in their study of the same name—“Foreign Currency Returns and Systemic Risks,” which appears in the April 2015 issue of The Journal of Financial and Quantitative Analysis—led Galsband and Nitschka to conclude that there is “a strong relation between currencies’ average returns and their sensitivities to cash-flow shocks in equity markets. High forward-discount currencies react strongly to stock-market cash flows while low forward-discount currencies are much more resilient in this regard.”
They write: “Basic finance theory suggests that high forward-discount currencies depreciate when the ‘home’ stock market receives bad cash-flow news that is associated with capital losses, whereas low forward-discount currencies appreciate under the same conditions. Thus, holding high forward-discount currencies is risky for a stockholder, while investing in low forward-discount currencies can provide him a hedge.”
Galsband and Nitschka found that their model “can explain between 81% and 87% in total variation in average returns on foreign-currency portfolios.” They go on to argue that “the free-lunch hypothesis on foreign-exchange markets is strongly rejected by the data” and that “making money on currency investments is tightly linked to bad news about future dividend payments on stock markets: high forward-discount currencies load more on cash-flow risk than their low forward-discount counterparts.”