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Handbook of Exchange Rates by Lucio Sarno, Ian Marsh, Jessica James

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10.4 Empirical Findings

In this section, I use the empirical methods outlined in the previous section to determine whether there is a candidate SDF that can price the returns to the carry trade. I begin by studying risk factors that have traditionally been used to explain stock returns. These include the CAPM, the Fama–French three factor model, models in which industrial production growth and stock market volatility are used as risk factors, and consumption-based models. I show that none of the SDFs specified in terms of these traditional risk factors explains the returns to the carry trade. I then turn to less traditional models in which the risk factors are, themselves, derived from currency returns. These models have varying degrees of success in pricing carry-trade returns.

10.4.1 Traditional Risk Factors

Models for Monthly Returns

Table 10.2 summarizes the results of running time-series regressions

Table 10.2 Monthly Factor Betas of the Carry-Trade Portfolios

NumberTable

described by Equation (10.20) for monthly models. Consider, first the CAPM model, which uses the market excess return as a single factor. For the EW carry-trade portfolio the beta is statistically insignificant. It is also economically small. To see this, consider that in order for the CAPM model to explain the return to holding the value weighted US stock market, the annualized value of λ must be approximately equal ...

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