Andrea Falconio - Working Paper Series - Carry trades and monetary conditions - No 1968 - October 2016

Sep 18, 2026

Uploaded by Anda

This paper investigates the relation between monetary conditions and the excess returns arising from a carry trade strategy, which borrows low-interest rate currencies and invests in high-interest rate currencies. Results show that carry trade average excess return, Sharpe ratio, and the 5% quantile differ markedly between expansive and restrictive conventional monetary policy before the financial crisis. In contrast, the same parameters are not affected by unconventional monetary policy during the crisis.

LanguageEnglish

CategoryResearch & Report

FormatPDF

Pages30

Reading Time1 h 16 min

AccessFree to download

Non-technical summary

1 Introduction

Andrea Falconio Working Paper Series Carry trades and monetary conditions No 1968 / October 2016 Note: This Working Paper should not be reported as representing the views of the European Central Bank (ECB) . The views expressed are those of the authors and do not necessarily reflect those of the ECB Abstract This paper investigates the relation between monetary conditions and the excess returns arising from an investment strategy that consists of borrowing low-interest rate currencies and investing in currencies with high interest rates, so-called \carry trade". The results indicate that carry trade average excess return, Sharpe ratio and 5% quantile di􀀋er substantially across expansive and restrictive conventional monetary policy before the onset of the recent 􀀌nancial crisis. By contrast, the considered parameters are not a􀀋ected by unconventional monetary policy during the 􀀌nancial crisis. Keywords: carry trade, volatility, monetary conditions JEL classi􀀌cation: F31, G15, E52 Non-technical summary One of the cornerstones of international 􀀌nance is the uncovered interest rate parity condition, which predicts that exchange rate changes will eliminate any pro􀀌t arising from the di􀀋erential in interest rates across countries. Nevertheless, many studies show that the opposite holds true empirically: high interest rate currencies tend to appreciate rather than depreciate against low interest rate currencies. This leads investors to engage in the so-called \carry trade", which is an investment strategy consisting of borrowing low-interest rate currencies and investing in currencies with high interest rates. The most persuasive explanation for carry trade pro􀀌tability is based on a risk argument: currencies with high interest rates are riskier than low interest rate currencies and so deliver higher expected returns. Empirical research has had serious problems in identifying which risk factors drive the considered returns. However, recent studies have shown that foreign exchange (FX) volatility risk and exposure to countries' external imbalances are keys to understanding rewards from carry trade. Against this background, my paper investigates the relation between monetary conditions and carry trade returns. To this end, an empirical analysis is carried out at the monthly frequency considering Federal Reserve (Fed) monetary policy as a proxy for changes in monetary conditions and using 37 daily spot and one month forward exchange rates per US dollar covering the period from November 1983 to June 2015 . Currencies are sorted into six portfolios according to their forward discounts (or, equivalently, their relative interest rate di􀀋erential versus U.S. money market interest rates): the zero cost strategy that goes long in portfolio 6 and short in portfolio 1 results in a carry trade portfolio. Carry trade portfolio returns are measured at time t based on monetary conditions at time t 􀀀 1. In this way, average returns, Sharpe ratiosand 5% quantiles are computed across di􀀋erent monetary conditions. My main result is that carry trade portfolio average return, Sharpe ratio and 5% quantile di􀀋er substantially across expansive and restrictive conventional monetary policy before the onset of the recent 􀀌nancial crisis. Speci􀀌cally, I 􀀌nd that expansive periods are characterised by signi􀀌cantly higher average returns and Sharpe ratios and lower downside risk. Concerning this, I argue that expansive conventional monetary policy is able to improve market expectations across countries and in this way lower FX volatility risk. This generatesa currency appreciation for net debtor nations and an increase in carry trade pro􀀌ts. Second, I present evidence suggesting that the considered parameters are similar across aggressive and stabilising unconventional monetary policy during the recent 􀀌nancial crisis. So, the Federal Reserve could not a􀀋ect market expectations during this time. For investors, this evidence suggests tha

FAQs

What is the main research question of the paper?

The paper studies how monetary conditions relate to excess returns generated by carry trades, where investors borrow low-interest rate currencies and invest in high-interest rate currencies.

Why is carry trade profitability often explained in the literature?

A common explanation is a risk argument: high interest rate currencies are viewed as riskier than low interest rate currencies, leading to higher expected returns.

How do conventional vs. unconventional monetary policy affect carry trade results?

Before the recent financial crisis, carry trade average returns, Sharpe ratios, and downside risk differ significantly between expansive and restrictive conventional policy. During the crisis, these parameters are not affected by unconventional monetary policy.

Sep 18, 2026

Uploaded by Anda