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Carry Trades and Global Foreign Exchange Volatility

Read the paperopens doi.org in a new tab

What they found

The authors showed that carry trade returns are largely explained by exposure to unexpected changes in global FX volatility. Using 48 currencies from 1983 to 2009, high-interest currencies delivered low returns when global FX volatility rose unexpectedly and low-interest currencies (like the yen and Swiss franc) delivered high returns in those states, acting as a hedge. A single volatility factor priced the cross-section of carry portfolios with a large negative premium, meaning investors pay to hold assets that do well when volatility spikes and demand compensation for the reverse.

See it drawn

Original diagrams for the ideas on this page. Illustrative, not real market data.

Contango and backwardationTwo futures curves against contract expiry: one rising above spot, one falling below it.The same commodity, priced for delivery at different dates.78.0076.0074.0072.0070.00Futures pricespot+1m+2m+3m+4m+5m+6mMonths until the contract expiresspot price74.00CONTANGOlater contracts cost more than spotBACKWARDATIONlater contracts cost less than spot
Contango and backwardation. A futures curve shows what buyers will pay for delivery in one month, two months and so on. When later contracts cost more than the spot price the curve is in contango; when they cost less it is in backwardation.

What you can use

  • Carry is short volatility: it pays in calm markets and loses when FX volatility spikes.
  • Funding currencies like the yen and Swiss franc are volatility hedges, which is why they rally in crises.
  • Sizing carry exposure by the level and trend of FX volatility is the research-supported way to manage it.

Caveats

Factor-pricing paper, not a timing strategy. Volatility innovations are measured ex post. Technical.

Tags: forex, carry, volatility, safe-haven

Summaries are our own reading of the paper, not the authors' words. Educational only, not advice. Discuss it in Book Club.