Explaining the Currency Carry Premium
The carry factor is the tendency for higher-yielding assets to provide higher returns than lower-yielding assets. A simplified description of the carry trade is the return an investor receives (net of financing) if an asset’s price remains the same.
The classic application is in currencies—the currency carry trade—which calls specifically for going long currencies of countries with the highest interest rates and shorting those with the lowest. Currency carry has been both a well-known and profitable strategy for several decades.
Pervasive Carry Premium
The carry trade is a general phenomenon, having been profitable across asset classes. For example, Ralph Koijen, Tobias Moskowitz, Lasse Pedersen and Evert Vrugt, authors of the 2013study “Carry,” found that a carry trade going long high-carry assets and short low-carry assets earns significant returns in various asset classes, with an annualized Sharpe ratio, on average, of 0.7.
For the period beginning in 1983 and ending in 2012, the authors found the currency carry trade produced an annual return of 5.3% with a Sharpe ratio of 0.68. It was also highly persistent, with the 1-, 3-, 5-, 10- and 20-year odds of producing a negative return being 25%, 12%, 6%, 2% and 0%, respectively.
However, they also found that individual carry strategies have excess kurtosis (fat tails) and exhibit sizable declines for extended periods of time coinciding with bad economic states, such as during recessions and in liquidity crises. This provides support for the theory that the excess return of the carry trade is compensation for bearing the risk that assets will perform poorly in bad times.
The carry trade is also investable, as the markets in which the carry trade invests are among the most liquid in the world. Thus, implementation costs are low. And carry has a simple, intuitive rationale arising from the long-established concept that prices balance out the supply and demand for capital across markets. High interest rates can signal an excess demand for capital not met by local savings, while low rates suggest an excess supply.
According to traditional economic theory, in what is known as uncovered interest parity (UIP), there should be an equality of expected returns on otherwise-comparable financial assets that are denominated in two different currencies. Rate differentials would be offset by currency appreciation or depreciation such that investor returns would be the same across markets. There is an overwhelming amount of empirical evidence, however, contradicting UIP theory, resulting in the UIP puzzle.
The UIP anomaly may be due to the presence of nonprofit-seeking market participants, such as central banks and corporate hedgers (companies that must convert currencies to conduct business abroad), introducing inefficiencies to currency markets and interest rates. The carry strategy is not without risk, as there can be instances when capital flees to low-yielding “safe havens.”
As mentioned earlier, this provides a simple risk-based explanation for the carry premium, in which positive performance over the long term is compensation for potential losses in bad economic environments. In other words, currencies that appreciate when the stock market falls might be a good investment, because they provide valuable insurance against unfavorable fluctuations in equity markets.
On the other hand, currencies that depreciate in times of poor stock market performance tend to further destabilize investors’ positions, and should therefore offer a premium for that risk. With these concepts in mind, we’ll review the literature on the currency carry trade.
Victoria Atanasov and Thomas Nitschka, authors of the 2015 study “Foreign Currency Returns and Systematic Risks,” found “a strong relation between currencies’ average returns and their sensitivities to cash-flow shocks in equity markets. High forward-discount currencies (currencies in which the futures trade at a large discount to the spot rate) react strongly to stock-market cash flows while low forward-discount currencies are much more resilient in this regard.”
They explain: “Basic finance theory suggests that high forward-discount currencies depreciate when the ‘home’ stock market receives bad cash-flow news that is associated with capital losses, whereas low forward-discount currencies appreciate under the same conditions. Thus, holding high forward-discount currencies is risky for a stockholder, while investing in low forward-discount currencies can provide him a hedge.”
The authors found their model “can explain between 81% and 87% in total variation in average returns on foreign-currency portfolios.”
Atanasov and Nitschka concluded: “The free-lunch hypothesis on foreign-exchange markets is strongly rejected by the data. We argue that making money on currency investments is tightly linked to bad news about future dividend payments on stock markets: high forward-discount currencies load more on cash-flow risk than their low forward-discount counterparts.”
Martin Lettau, Matteo Maggiori and Michael Weber, authors of the 2014 study “Conditional Risk Premia in Currency Markets and Other Asset Classes,” also provide a risk-based explanation for the success of the carry trade. Their study covered the period January 1974 through March 2010 and more than 50 currencies.
The authors found that “while high yield currencies have higher betas (exposure to equity market risk) than lower yield currencies, the difference in betas is too small to account for the observed spread in currency returns.”
Pasquale Della Corte, Steven Riddiough and Lucio Sarno, authors of the study “Currency Premia and Global Imbalances,” which covered a broad sample of 55 currencies and a subsample of 15 developed-market currencies for the period October 1983 through June 2014, provided empirical evidence that exposure to countries’ external imbalances (trade and capital accounts) is a key component to understanding currency risk premiums—countries run trade imbalances and financiers absorb the resultant currency risk. In other words, financiers are long the debtor country and short the creditor country.
The authors’ hypothesis was that currency excess returns are higher when the funding (investment) country is a net foreign creditor (debtor) and has a higher propensity to issue liabilities denominated in domestic (foreign) currency. The relationship between currency excess returns and net foreign assets captures the link between external imbalances and currency risk premiums.
Currency Risk-Premium Drivers
Della Corte, Riddiough and Sarno also found the currency denomination of external debt matters for currency risk premiums. Countries that cannot issue debt in their own currency are riskier. Thus, currency risk premiums are driven by the evolution and currency denomination of net foreign assets.
Specifically, in the presence of a financial disruption (i.e., risk-bearing capacity is low and global risk aversion is high), net-debtor countries experience a currency depreciation, unlike net-creditor countries.
This risk generates currency risk premiums: Investors demand a risk premium for holding net-debtor countries’ currencies because these currencies perform poorly in bad times, which are times of large shocks to global risk aversion.
Specifically, they found that a currency strategy that buys the extreme net-debtor countries with the highest propensity to issue external liabilities in foreign currency and sells the extreme creditor countries with the lowest propensity to issue liabilities in foreign currency (a global imbalance strategy) generates Sharpe ratios of 0.59 for a universe of major countries and 0.68 for the broader set of 55 countries. The excess return is greater than 5% per year.
The authors concluded: “Returns to carry trades are compensation for time-varying fundamental risk, and thus carry traders can be viewed as taking on global imbalance risk.” They add: “Global imbalances are a key driver of currency risk premia: net debtor currencies are predicted to warrant an excess currency return in equilibrium and to depreciate at times when risk-bearing capacity falls.”
Regina Hammerschmid and Alexandra Janssen provide the latest contribution to the literature on the currency carry trade with their September 2018 study “Crash-o-phobia in Currency Carry Trade Returns.”
They noted that, historically, currency carry trade returns display both high downside market risk and high crash risk (the presence of rare disasters such as the “peso problem”). These are risks for which investors should be compensated. And because investors tend to be risk averse, assets that perform badly in bad times should have large risk premiums. Their data sample, restricted by the availability of currency options prices, covers the period October 2003 through June 2016.
Following is a summary of their findings, which are consistent with the theory of investor risk aversion first proposed by Amos Tversky and Daniel Kahneman in their famous paper “Advances in Prospect Theory: Cumulative Representation of Uncertainty.” The findings are also consistent with the prior research cited above.
- Currency carry trade returns are on average large and non-normally distributed.
- Investor loss aversion and overweighting of low probability events (crash-o-phobia) explains the carry premium.
There’s one other study we need to cover that provides evidence investors should consider before adding a currency carry trade allocation to their portfolio. Klaus Grobys and Jari-Pekka Heinonen, authors of the study “Is There a Credit Risk Anomaly in FX Markets?” which was published in the August 2016 issue of Finance Research Letters, examined whether a link exists between sovereign credit ratings and currency returns. The availability of credit rating data dictated the sample period, which was the relatively short time frame from January 1998 through December 2010.
The authors divided a sample of 39 currencies into three portfolios by sorting on the previous month’s Oxford Economics sovereign credit rating. Portfolios were formed by going long the one-third of currencies with the lowest credit rating and short the one-third of currencies with the highest credit rating. Following is a summary of their surprising findings:
- While premiums were found for the carry trade, volatility and momentum, there was a negative premium of 0.30% per month for the credit strategy. And importantly, the data was statistically significant at the 1% level.
- Average portfolio returns sorted by credit risk decrease linearly as they move from the low-credit-risk portfolio to the high-credit-risk portfolio. This suggests higher credit risk is associated with lower returns. In addition to negative returns, the long low-credit-quality and short high-credit-quality portfolio has a non-normal distribution. There is negative skewness (-0.5) and excess kurtosis (2.9), or a fat tail.
The authors concluded: “Even though risk-based asset pricing theory suggests that riskier assets should generate higher payoffs than less risky assets, our results suggest that currencies of countries with a high credit risk tend to generate lower returns than currencies of less risky countries.”
An important portfolio implication is that investors should account for credit risk when implementing a carry strategy. For example, investors can pursue carry only in the currencies of countries with high-quality sovereign debt, or avoid going long low-quality sovereign debt.
The academic literature shows that investments in high-interest currencies deliver large positive returns. However, the distribution of returns is negatively skewed, exhibits fat tails and crashes occasionally due to rare events, or systematically along with the stock market.
The evidence is persistent across long periods of time, pervasive across asset classes, is implementable and has intuitive risk-based explanations, as the large premium associated with the carry trade is well explained by linkages between exchange rate returns and macroeconomic fluctuations.
Thus, we have fundamental and theoretically motivated sources of risk driving currency returns. These explanations also provide a logical resolution to the UIP puzzle.
At Buckingham Strategic Wealth, we access the carry trade in a diversified way (across stocks, bonds, commodities and currencies)—which greatly reduces the crash risk—through investments in AQR’s Style Premia Alternative Fund (QSPRX) and Alternative Risk Premia Fund (QRPRX).
These funds provide exposure to multiple factors across multiple asset classes. QSPRX provides exposure to factors of value, cross-sectional momentum, carry and defensive across stocks, bonds, commodities and currencies. QRPRX provides exposure to the same four factors plus time-series momentum and the equity variance premium across stocks, bonds and currencies. (Full disclosure: My firm, Buckingham Strategic Wealth, recommends AQR funds in constructing client portfolios.)
This commentary originally appeared November 9 on ETF.com
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