The Carry Trade and Implied Moment Risk

The carry trade is a zero net investment strategy that borrows in low yielding currencies and subsequently invests in high yielding currencies. It has been identified as highly profitable FX strategy delivering significantly excess returns with high Sharpe ratios. This paper shows that these excess returns are especially compensation for bearing FX variance and negative skewness risk. Additionally, factor risks that affect foreign money changes, foreign inflation changes, as well as changes to a newly developed Carry Trade Activity Index and the VIX index, as a proxy for global risk aversion, make up the carry trade risk anatomy. These findings are not exclusively important for carry traders, but also contribute to the understanding of currency risk in the cross-section. This is directly linked to asset pricing tests from Lustig et al. (2011), which have shown that currency baskets sorted on their interest rate differentials are all exposed to carry trade returns as a risk factor. Furthermore, this paper finds evidence that a decreased level of funding liquidity potentially leads to carry trade unwindings, controlling for equity and FX implied variance and skewness effects, which supports the theoretical model of liquidity spirals developed by Brunnermeier and Pedersen (2009).