Expected Returns: An Investor's Guide to Harvesting Market Rewards

13

Currency carry

• Buying high-yielding currencies and shorting low-yielding currencies has been a profitable strategy for 50+ years.

• Academic theories suggest that any initial cross-country yield advantage should be offset by future currency depreciation. In practice, this has not happened on average, and naive yield seeking has paid off. Forward rates have been biased predictors of future spot exchange rates.

• Carry strategies within G10 markets have an attractive long-run Sharpe ratio—which is even higher in emerging markets and higher if refinements or carry timing are used. As a result, the strategy became very crowded before 2008.

• Success increasingly looks like compensation for the strategy’s riskiness, however. A carry strategy resembles selling lottery tickets that pay off in bad times. The combination of negative skew (frequent small gains punctuated by infrequent large losses) and terrible timing of losses warrants a large risk premium.

• Alternative explanations include biased investor expectations and so-called peso problems.

• Yield seeking adds value in the long run in many other asset classes besides currencies. Yet, the reward-to-risk ratio has been noticeably higher in cross-country carry strategies than in other carry strategies, such as within-country credit or term carry strategies.

13.1 INTRODUCTION

The second dynamic strategy I study is yield-seeking carry trading, with a focus on FX (see cube). A currency carry trade involves investment in a high-yielding ...