DP7345 | The Time-Varying Systematic Risk of Carry Trade Strategies

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This paper suggests a factor model for carry trade strategies where the regression coefficients are allowed to depend on market volatility and liquidity. Empirical results on daily data from 1995 to 2008 show that a typical carry trade strategy has much higher exposure to the stock market and also more mean reversion in volatile periods - and that FX market volatility is a priced risk factor. The findings are robust to various extensions, including using more currencies and other proxies for volatility and liquidity (VIX, TED and a bid-ask spread).