Carry Trades and Global Foreign Exchange Volatility

  • Author(s): LUKAS MENKHOFF, LUCIO SARNO, MAIK SCHMELING, ANDREAS SCHRIMPF
  • Published: Mar 27, 2012
  • Pages: 681-718
  • DOI: 10.1111/j.1540-6261.2012.01728.x

ABSTRACT

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.

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