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.”
Systemic Risk And Regime Dependency
These findings are consistent with prior research on the subject. For example, Charlotte Christiansen, Angelo Ranaldo and Paul Soderlind—authors of the 2010 study “The Time-Varying Systematic Risk of Carry Trade Strategies”—analyzed whether the systematic risk of a typical carry trade strategy is in fact time-varying and regime dependent.
The study covered the period from 1995 through 2008 and included as many as 30 countries. The authors found that the currency carry trade is exposed to risks of the stock and bond market as well as to the risk of volatility in the foreign exchange market. In other words, its success is regime dependent.
They also found that individual currency returns have fat tails (excess kurtosis), creating the potential for large losses during times of crisis. When the risk appetite of investors decreases, and they move to safe assets such as U.S. Treasury bonds, investment currencies lose value against funding currencies.
Excess Returns Come With Extra Risk
Hanno Lustig, Nikolai Roussanov and Adrien Verdelhan—authors of “Common Risk Factors in Currency Markets,” which appeared in the November 2011 issue of The Review of Financial Studies—found that, even after expenses, net returns of the carry trade were in excess of 4.5 percent. And their results were statistically significant.
They also found that the premium is related to changes in global equity market volatility. High (low) interest-rate currencies tend to depreciate (appreciate) when global equity volatility is high. The study’s authors concluded that by investing in high-interest-rate currencies and borrowing in low-interest-rate currencies, U.S. investors are loading up on global risk.
Volatility Explains The Returns
Lukas Menkhoff, Lucio Sarno, Maik Schmeling and Andreas Schrimpf—authors of the study “Carry Trades and Global Foreign Exchange Volatility,” which appeared in the April 2012 issue of the Journal of Finance—found that more than 90 percent of the cross-sectional excess returns from the carry trade was explained by FX volatility, providing further evidence that the excess return is a result of an economically meaningful risk/return relationship.
In times of heightened volatility, lower-interest-rate currencies offer insurance because their exchange rate appreciates in response to adverse global shocks. Thus, “safe havens” (such as the Swiss franc) earn a lower risk premium than currencies perceived as more risky. Safe-haven currencies tend to appreciate when market risk and illiquidity increase.
These results shed light on the risks associated with carry-trade strategies. In turbulent times, the systematic risk of the carry trade increases significantly, as does its exposure to other risky allocations. This finding should be a warning against the apparent attractiveness of the carry trade as depicted by simple performance measures, such as the Sharpe ratio.
In other words, on average, the carry trade strategy yields moderately high returns in normal periods. But keep in mind that a person can drown in a stream with a depth of only six inches. The carry trade, on average, shows dramatic losses during turbulent periods.
The bottom line is that the risk of large losses results from the carry trade’s exposure to the stock market and bond markets of the local currencies, thus providing a logical resolution to the UIP puzzle.
These findings also have important implications for investors in the carry trade and for investors who purchase unhedged foreign currency denominated bonds.
Such investors should be cognizant of the fact that these investments exhibit both negative skewness and excess kurtosis, creating the potential for large losses. Moreover, they must understand that the correlation of returns to the carry trade and high-yielding foreign-currency-denominated bonds to other risky assets all tend to rise sharply toward one at exactly the wrong time.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.