Effect of Exchange Rate Volatility on Currency Carry Trade and risk factor compensation of Currency Carry trade in G10 and Emerging Market

Abstract

Currency carry trade is one of famous currency speculation strategies through latest decade. Return of this strategy comes from the difference of interest rate between countries. In theoretical world, FAMA uncovered interest rate parity (UIP) assumes change in spot exchange rate is going to offset the difference of interest rate. Therefore, the first objective of this paper is to test violation of UIP which implies possibility to do currency carry trade. Secondly, moving on to determine the relationship between currency carry trade return and exchange rate volatility in some difference aspects because there are evidences about negative relationship between currency carry trade return and market volatility which is exchange rate volatility from previous literature. Finally, this paper employs factor model to investigate the contribution of risk factor such as yield curve factors and investors’ fear factors on currency carry trade return. The groups of data which are considered in this paper are G10 and Emerging countries. According to first empirical result of this paper, it shows the violation of UIP which implies opportunity to earn profit from currency carry trade strategy, since change in spot exchange rate does not offset difference of interest rate. Secondly, the negative relationship between currency carry trade return and exchange rate volatility is consistently appeared while we go through steps of investigating the relationship. This result also accorded with previous literatures which had concluded that currency carry trade strategy is likely to yield favorable return while exchange rate volatility is low and vice versa. Finally, the factor model also yields result consistent with previous works whether it would be significantly negative, significantly negative and positive relationship for VIX index, yield curve slope factor and yield curve level factor to currency carry trade return respectively. Moreover, lagged unexpected volatility also yields significantly negative relationship as well.