Faculty of Economics and Business Administration Publications Database

Carry Trades and Global Foreign Exchange Volatility

Menkhoff, Lukas
Sarno, Lucio
Schrimpf, Andreas
Volume: 67
Number: 2
Pages: 681 - 718
Month: April
ISSN-Print: 0022-1082
Link External Source: Online Version
Year: 2012

We investigate the relation between global foreign exchange (FX) volatility risk and the cross section of excess returns arising from popular strategies that borrow in low interest rate currencies and invest in high interest rate currencies, so‐called “carry trades.” We find that high interest rate currencies are negatively related to innovations in global FX volatility, and thus deliver low returns in times of unexpected high volatility, when low interest rate currencies provide a hedge by yielding positive returns. Furthermore, we show that volatility risk dominates liquidity risk and our volatility risk proxy also performs well for pricing returns of other portfolios.