Carry Trader

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CFR (draft), XXXX, XX: 1–62

The Carry Trade: Risks and Drawdowns


Kent Daniel
Robert J. Hodrick
Zhongjin Lu
1
Columbia Business School, Columbia University, New York, NY 10027 and
National Bureau of Economic Research (NBER), Cambridge, MA 02138;
kd2371@columbia.edu.
2
Columbia Business School, Columbia University, New York, NY 10027 and
National Bureau of Economic Research (NBER), Cambridge, MA 02138;
rh169@columbia.edu
3
Terry College of Business, University of Georgia, Athens, GA 30602;
zlu15@uga.edu.

ABSTRACT
We find important differences in dollar-based and dollar-neutral
G10 carry trades. Dollar-neutral trades have positive average
returns, are highly negatively skewed, are correlated with risk
factors, and exhibit considerable downside risk. In contrast, a
diversified dollar-carry portfolio has a higher average excess
return, a higher Sharpe ratio, minimal skewness, is uncondi-
tionally uncorrelated with standard risk-factors, and exhibits
no downside risk. Distributions of drawdowns and maximum
losses from daily data indicate a role for time-varying autocor-
relation in determining negative skewness at longer horizons.

Keywords: currency carry trade, currency risk factors, market efficiency


JEL Codes: F31, G12, G15

This research was supported by a grant from the Network for Study on Pensions, Aging,
and Retirement to the Columbia Business School. We thank two anonymous referees, Craig
Burnside, Mike Chernov, Victoria Dobrynskaya, Pab Jotikasthira, Campbell Harvey, Hanno

ISSN XXXX-XXXX; DOI XX.XXXX/104.0000


© XXXX CFR (draft) and Kent Daniel, Robert J. Hodrick and Zhongjin Lu
2 Kent Daniel et al

1 Introduction

This paper empirically examines returns to carry trades in the major inter-
national currency markets including their exposures to various risk factors.
A carry trade is an investment in a high interest rate currency that is funded
by borrowing in a low interest rate currency. The ‘carry’ is the ex-ante
observable positive interest differential. Returns to the carry trades are un-
certain because the exchange rate between the two currencies may change.
An individual carry trade is profitable when the high interest rate currency
depreciates relative to the low interest rate currency by less than the interest
differential.1
Carry trades are known to have high Sharpe ratios, as emphasized
by Burnside et al. (2011a). Consistent with this, our baseline carry trade
has an annualized Sharpe ratio of 0.78 over the 1976:02-2013:08 sample
period. Alternative versions, which we discuss below, have Sharpe ratios
as high as 1.02.
While such return premiums are obviously inconsistent with the theory
of uncovered interest rate parity, the academic literature offers numerous
explanations for the existence of these return premiums. Brunnermeier
et al. (2008) document that returns to standard carry trades are negatively
skewed and exhibit infrequent large losses. While their evidence is sug-
gestive that such downside risk could be priced, they do no formal asset
pricing tests. Negative skewness per se is not enough to explain the prof-
itability of carry trades as Bekaert and Panayotov (2015) develop “good”
carry trades that retain high average returns and do not have significantly
negative skewness. Lettau et al. (2014) and Dobrynskaya (2014) find that
carry trade portfolio returns are differentially exposed to the return on the
equity market when the market is significantly down. They estimate a high
price of downside risk and conclude that such downside risk explains the

Lustig, Nick Roussanov, Ivo Welch and the participants of the 2015 NBER International
Asset Pricing Summer Institute, the 2016 Vanderbilt FMRC Conference on International
Finance, and the 2016 China International Conference in Finance for helpful comments
and suggestions. We especially thank Pierre Collin-Dufresne for many substantive early
discussions that were fundamental to the development of the paper. We also thank Elessar
Chen for his research assistance, and Ken French, Jakub Jurek, Tracy Johnson, Lucio Sarno,
Maik Schmeling, and Adrien Verdelhan for providing data.
1
Koijen et al. (2015) explore the properties of ‘carry’ trades in other asset markets
by defining ‘carry’ as the expected return on an asset assuming that market conditions,
including the asset’s price, stay the same.
The Carry Trade: Risks and Drawdowns 3

profitability of the carry trade. Jurek (2014) similarly finds that currency
carry trades are strongly exposed to the returns of the Jurek and Stafford
(2015) downside risk index (DRI) portfolio, and he concludes that the
abnormal returns of currency carry trades are indistinguishable from zero
after controlling for their exposure to DRI and other equity risk factors.
Lustig et al. (2014) find that the average forward discount of currencies rel-
ative to the U.S. dollar is a particularly strong predictor of excess currency
returns. They conclude that common movements of the dollar relative to
all currencies are a primary driver of dollar-based carry trade returns.
We examine these and other potential explanations for carry trade
premiums by decomposing the standard carry trade into dollar-carry and
dollar-neutral-carry components. The carry trade, as commonly imple-
mented in academic studies, can have a large positive or negative exposure
to the U.S. dollar, depending on the level of USD interest rates relative to
the median non-USD interest rate. Our diversified, dynamic dollar strategy
captures this time-varying dollar exposure.
We show that the majority of the excess return of our basic carry trade
is attributable to the time-varying dollar component. This view supports
the analysis of Lustig et al. (2014) who develop a dollar-carry strategy
based on the average forward discount with a larger set of currencies
than ours. We find that the average excess return of the dollar-neutral
component of our basic carry trade is different from zero, but the returns
are highly negatively skewed, are correlated with standard risk factors, and
exhibit considerable downside risk. In contrast, a dynamic dollar strategy
diversified across the G10 currencies has a higher average excess return, a
higher Sharpe ratio, minimal skewness, is uncorrelated with standard risk-
factors, and exhibits no downside risk. While Lustig et al. (2014) conclude
that their multi-country affine model is consistent with the observed returns
on their dollar-carry strategy, we argue that the priced risks in such a model
would manifest themselves in statistically significant coefficients in our
asset pricing regressions, which we do not observe. We consequently do
not interpret our results through the lens of their model.
Additionally, we examine how spread-weighting and risk-rebalancing
affect the profitability and risk of the basic carry trade. Our spread weighted
portfolio conditionally invests more in the currencies with the highest inter-
est differentials relative to the dollar. We also employ a simple estimated
covariance matrix of the currency returns that allows us to reduce the
overall risk of our carry trade portfolios in recognition that traders face
4 Kent Daniel et al

limits on losses that require reductions in the sizes of trades when volatility
increases. The covariance matrix is also used in a sequential mean-variance
optimization. Spread-weighting and risk-rebalancing enhance the perfor-
mance of the carry trade. For the equal-weighted carry trade, we also
show that returns are dependent on the base currency with the dollar base
providing the largest average return.
We conclude our analysis with a study of the drawdowns to carry
trades.2 We define a drawdown to be the loss that a trader experiences
from the peak (or high-water mark) to the trough in the cumulative return
to a trading strategy. We also examine pure drawdowns, as in Sornette
(2003), which are defined to be persistent decreases in an asset price over
consecutive days. We document that carry trade drawdowns are large and
occur over substantial time intervals. We contrast these drawdowns with
the characterizations of carry trade returns by The Economist (2007) as
“picking up nickels in front of a steam roller,” and by Breedon (2001) who
noted that traders view carry trade returns as arising by “going up the stairs
and coming down the elevator.” Both of these characterizations suggest that
negative skewness in the trades is substantially due to unexpected sharp
drops. In contrast to these characterizations, our analysis of daily returns
suggests that a large fraction of the documented negative return skewness
of carry trades results from the time varying return autocorrelations of
daily carry returns: the large drawdowns in carry trade returns result from
sequences of losses rather than large single-day drops.

2 Background Ideas and Essential Theory

By covered interest rate parity, the interest differential is linked to the


forward premium or discount. Absence of covered interest arbitrage oppor-
tunities implies that high interest rate currencies trade at forward discounts
relative to low interest rate currencies, and low interest rate currencies
trade at forward premiums. Thus, the carry trade can also be implemented
in forward foreign exchange markets by going long (short) in currencies
trading at forward discounts (premiums). Such forward market trades
are profitable as long as the currency trading at the forward discount
2
Melvin and Shand (2014) analyze carry trade drawdowns including the dates and
durations of the largest drawdowns and the contributions of individual currencies to the
portfolio drawdowns.
The Carry Trade: Risks and Drawdowns 5

depreciates less than the forward discount.


Because the carry trade can be implemented in the forward market, it
is intimately connected to the forward premium anomaly – the empirical
finding that the forward premium on the foreign currency is not an unbiased
forecast of the rate of appreciation of the foreign currency. In fact, expected
profits on the carry trade would be zero if the forward premium were an
unbiased predictor of the rate of appreciation of the foreign currency.3
Thus, the finding of non-zero profits on the carry trade can be related to
the classic interpretations of the apparent rejection of the unbiasedness
hypothesis. The profession has recognized that there are four ways to
interpret the rejection of unbiased forward rates. First, the difference
between forward rates and expected future spot rates could result from an
equilibrium risk premium. Second, the foreign exchange market could be
inefficient. Third, rational expectations might not characterize expectations
if investors must learn about their environment, and fourth, so-called peso
problems might be present in which the ex post realizations of returns do
not match the ex ante frequencies from investors’ subjective probability
distributions.
Each of these themes plays out in the recent literature on the carry
trade. Lustig and Verdelhan (2007) show that high interest rate currencies
are more exposed to aggregate consumption growth risk than low interest
rate currencies using 81 currencies and 50 years of data. Bansal and
Shaliastovich (2013) argue that an equilibrium long-run risks model is
capable of explaining the predictability of returns in bond and currency
markets. Lustig et al. (2014) develop a theory of countercyclical currency
risk premiums. Carr and Wu (2009) and Jurek and Xu (2013) develop
formal theoretical models of diffusive and jump currency risk premiums.
Several papers find empirical support for the hypothesis that returns to
the carry trade are exposed to priced risk factors. For example, Lustig et al.
(2011) argue that common movements in the carry trade across portfolios
of currencies indicate rational risk premiums. Rafferty (2012) relates carry

3
Hassan and Mano (2015) find that 70% of carry trade profitability is due to static
interest rate differentials, while Bekaert and Panayotov (2015) develop static trades that
are 50% as profitable as their more dynamic ones. Because a substantive fraction of carry
trade profitability is effectively unconditional, while rational explanations of the forward
premium anomaly typically involve dynamic, time-varying risk premiums, Hassan and
Mano (2015) argue that reconciling carry trade profitability and the forward premium
anomaly may require separate explanations.
6 Kent Daniel et al

trade returns to a skewness risk factor in currency markets. Dobrynskaya


(2014) and Lettau et al. (2014) argue that large average returns to high
interest rate currencies are explained by their high conditional exposures
to the market return in the down state. Jurek (2014) demonstrates that
the return to selling S&P 500 index puts, which has severe downside risk,
explains the carry trade. Christiansen et al. (2011) note that carry trade
returns are more positively related to equity returns and more negatively
related to bond risks the more volatile is the foreign exchange market.
Ranaldo and Söderlind (2010) argue that the funding currencies have ‘safe
haven’ attributes, which implies that they tend to appreciate during times
of crisis. Menkhoff et al. (2012) argue that carry trades are exposed to
global FX volatility risk. Beber et al. (2010) note that the yen-dollar carry
trade performs poorly when differences of opinion are high. Mancini et al.
(2013) find that systematic variation in liquidity in the foreign exchange
market contributes to the returns to the carry trade. Bakshi and Panayotov
(2013) include commodity returns as well as foreign exchange volatility
and liquidity as risk factors. Sarno et al. (2012) estimate multi-currency
affine models with four dimensional latent variables. They find that such
variables can explain the predictability of currency returns, but there is a
tradeoff between the ability of the models to price the term structure of
interest rates and the currency returns. Bakshi et al. (2008) use option
prices to infer the dynamics of risk premiums for the dollar, pound and yen
pricing kernels.
Burnside et al. (2011a) provide an alternative explanation of carry-trade
profitability by focusing on peso problems. They examine returns to both
standard, unhedged carry trades and carry trades that are hedged against
downside risks using option strategies. In contrast to the above studies that
find carry trades have exposure to substantive financial risks, Burnside et al.
(2011a) find that their unhedged carry trades have high profitability but no
exposure to a variety of standard sources of risk. But, their hedged carry
trades, which also have significant average returns, are exposed to these
risks. By postulating an unobserved peso state that occurs with a small
probability, Burnside et al. (2011a) determine that the peso state involves
a very high value for the stochastic discount factor. Jurek (2014) also
examines the unhedged and hedged carry trades using out-of-the-money
options and an alternative hedging procedure that employs all bilateral
option pairs rather than just dollar denominated ones. He concludes that
peso states explain at most one-third of the average returns to the carry
The Carry Trade: Risks and Drawdowns 7

trade. Farhi and Gabaix (2016) and Farhi et al. (2015) also argue that
the carry trade is exposed to rare crash states in which high interest rate
currencies depreciate. Burnside (2012) reviews the literature examining
the risks of carry trades.
Jordà and Taylor (2012) dismiss the profitability of the naive carry
trade based only on interest differentials as poor given its performance
in the financial crisis of 2008, but they advocate simple modifications of
the positions based on long-run exchange rate fundamentals that enhance
its profitability and protect it from downside moves indicating a market
inefficiency.

2.1 Implementing the Carry Trade

This section develops notation and provides background theory that is


useful in interpreting the empirical analysis. Let the level of the exchange
rate of dollars per unit of a foreign currency be S t , and let the forward
exchange rate that is known today for exchange of currencies in one period
be F t . Let the one-period dollar interest rate be i t$ , and let the one-period
foreign currency interest rate be i t∗ .4 Consistent with much of the literature,
we take the holding period to be one month.
We explore several versions of the carry trade. The one most often
studied in the literature is equal weighted in that it goes long (short) an
equal dollar amount of each currency for which the interest rate is higher
(lower) than the dollar interest rate. If the carry trade is done by borrowing
and lending in the money markets, the dollar payoff to the carry trade for
a single foreign currency – ignoring transaction costs – is:

S t+1
z t+1 = [(1 + i t∗ ) − (1 + i t$ )] y t (1)
St

where 
+1 if i t∗ > i t$

yt =
−1 if i t$ > i t∗
Equation (1) scales the size of returns to the carry trade either by
borrowing one dollar and investing in the foreign currency money market,
or by borrowing the appropriate amount of foreign currency to invest one

4
When it is necessary to distinguish between the dollar exchange rate versus various
currencies or the various interest rates, we superscript them with numbers.
8 Kent Daniel et al

dollar in the dollar money market. When covered interest rate parity holds,
if i t∗ > i t$ , then F t < S t ; that is the foreign currency is at a discount in
the forward market. Conversely, if i t∗ < i t$ , then F t > S t ; and the foreign
currency is at a premium in the forward market. Thus, the carry trade can
also be implemented by going long (short) in the foreign currency in the
forward market when the foreign currency is at a discount (premium) in
terms of the dollar. Let w t be the amount of foreign currency bought in
the forward market. The dollar payoff to this strategy is:

z t+1 = w t (S t+1 − F t ). (2)

To scale the forward positions to be either long or short in the forward


market an amount equivalent to one dollar in the spot market as in equation
(1), let
 1
F t (1 + i t ) if F t < S t
$

wt = (3)
− F1t (1 + i t$ ) if F t > S t

When covered interest rate parity holds, and in the absence of transac-
tion costs, the forward market strategy for implementing the carry trade in
equation (2) is exactly equivalent to the carry trade strategy in equation
(1). Unbiasedness of forward rates and uncovered interest rate parity imply
that carry trade profits should average to zero.
Uncovered interest rate parity ignores the possibility that changes in the
values of currencies are exposed to risk factors, in which case risk premiums
can arise. To incorporate risk aversion, we need to examine pricing kernels.

2.2 Pricing Kernels

One of the fundamentals of no-arbitrage pricing is that there is a dollar


pricing kernel or stochastic discount factor, M t+1 , that prices all dollar
returns R t+1 (i.e., time t+1 payoffs that result from a one dollar investment
at time t):
E t [M t+1 R t+1 ] = 1 (4)

Because carry trades implemented in the forward market are zero-investment


portfolios, the no-arbitrage condition is:

E t [M t+1 z t+1 ] = 0 (5)


The Carry Trade: Risks and Drawdowns 9

Taking the unconditional expectation of equation (5) and rearranging gives

−cov(M t+1 , z t+1 )


E[z t+1 ] = (6)
E[M t+1 ]

That is, the expected return to the carry trade will be positive if its covaria-
tion with the stochastic discount factor is negative.5

2.3 The Hedged Carry Trade

Burnside et al. (2011b), Caballero and Doyle (2012), Farhi et al. (2015),
and Jurek (2014) examine hedging the downside risks of the carry trade by
purchasing insurance in the foreign currency option markets. To examine
this analysis, let C t and Pt be the dollar prices of one-period foreign currency
call and put options with strike price K on one unit of foreign currency.
Buying one unit of foreign currency in the forward market costs F t dollars
in one period, which is an unconditional future (time t +1) cost. One can
also unconditionally buy the foreign currency forward by buying a call
option with strike price K and selling a put option with the same strike
price, in which case the future cost is K + C t (1 + i t$ ) − Pt (1 + i t$ ). To prevent
arbitrage, these unconditional future costs must be equal, which implies

F t = K + C t (1 + i t$ ) − Pt (1 + i t$ ). (7)

This is the put-call parity relationship for foreign currency options.


Now, suppose a dollar-based speculator wants to be long w t units of
foreign currency in the forward market. The payoff is negative if the
realized future spot exchange rate—expressed in dollars per unit of foreign
currency—is less than the forward rate. To place a floor on losses from a
depreciation of the foreign currency, the speculator can hedge by purchasing
out-of-the-money put options on the foreign currency. If the speculator
borrows the funds to buy put options on w t units of foreign currency, the
5
Examples of such models include Nielsen and Saá-Requejo (1993) and Frachot (1996),
who develop the first no arbitrage pricing models; Backus et al. (2012), who offer an
explanation in terms of monetary policy conducted through Taylor Rules; Farhi and Gabaix
(2016), who develop a crash risk model; Bansal and Shaliastovich (2013) who develop a
long run risks explanation; and Lustig et al. (2014) who calibrate a no-arbitrage model
of countercyclical currency risks. Sarno et al. (2012) estimate an affine model of the
bond markets in two currencies and the rate of depreciation in the corresponding currency
market.
10 Kent Daniel et al

option payoff is [max(0, K − S t+1 ) − Pt (1 + i t$ )]w t . The dollar payoff from


the hedged long position in the forward market is therefore the sum of the
payoffs resulting from the forward purchase of the foreign currency and
the option:
H
z t+1 = [S t+1 − F t + max (0, K − S t+1 ) − Pt (1 + i t$ )]w t

Substituting from put-call parity gives


H
z t+1 = [S t+1 − K + max (0, K − S t+1 ) − C t (1 + i t$ )]w t . (8)

When S t+1 < K, [S t+1 − K + max (0, K − S t+1 )] = 0; and if S t+1 > K,
max(0, K − S t+1 ) = 0. Hence, we can write equation (8) as
H
z t+1 = [max (0, S t+1 − K) − C t (1 + i t$ )]w t ,

which is the return to borrowing enough dollars to buy call options on


w t units of foreign currency. Thus, hedging a long forward position by
buying out-of-the-money put options with borrowed dollars is equivalent
to implementing the trade by directly borrowing dollars to buy the same
foreign currency amount of in-the-money call options with the same strike
price.
Now, suppose the dollar-based speculator wants to sell w t units of
the foreign currency in the forward market. An analogous argument can
be used to demonstrate that hedging a short forward position by buying
out-of-the-money call options is equivalent to implementing the trade by
directly buying in-the-money foreign currency put options with the same
strike price.
We examine hedged carry trades implemented with either 10∆ or 25∆
options, where ∆ measures the sensitivity of the option price to movements
in the underlying exchange rate.6 Specifically, for the 10∆ strategy, we
combine each long (short) position in a foreign currency with the purchase
an out-of-the money put (call) with ∆ = −0.10 (0.10). Because the hedged
carry trades are also zero net investment strategies, their returns must also
satisfy equation (5).

The ∆ of an option is the derivative of the value of the option with respect to a change
6

in the underlying spot rate. A 10∆ (25∆) call option increases in price by 0.10 (0.25)
times the small increase in the spot rate. The ∆ of a put option is negative.
The Carry Trade: Risks and Drawdowns 11

3 Data

In constructing our carry trade returns, we use data on the world’s major
currencies, the so-called G10 currencies: the Australian dollar (AUD), the
British pound (GBP), the Canadian dollar (CAD), the euro (EUR) spliced
with historical data from the Deutsche mark, the Japanese yen (JPY), the
New Zealand dollar (NZD), the Norwegian krone (NOK), the Swedish krona
(SEK), the Swiss franc (CHF), and the U.S. dollar (USD).7 All spot and
forward exchange rates are dollar denominated and are from Datastream
and IHS Global Insight. For most currencies, the beginning of the sample is
January 1976, and the end of the sample is August 2013, which provides
a total of 451 monthly observations on the carry trade. Data for the AUD
and the NZD start in October 1986. Interest rate data are eurocurrency
interest rates from Datastream.
We explicitly exclude the European currencies other than the euro (and
its precursor, the Deutsche mark), because we know that several of these
currencies, such as the Italian lira, the Portuguese escudo, and the Spanish
peseta, were relatively high interest rate currencies prior to the creation of
the euro. At that time traders engaged in the “convergence trade,” which
was a form of carry trade predicated on a bet that the euro would be
created in which case the interest rates in the high interest rate countries
would come down and those currencies would strengthen relative to the
Deutsche mark. An obvious peso problem exists in these data because there
was uncertainty about whether the euro would indeed be created. If the
euro had not succeeded, the high interest rate currencies, such as the lira,
escudo, and peseta, would have suffered large devaluations relative to the
Deutsche mark, drastically lowering the return to the convergence trade.
We also avoid emerging market currencies because nominal inter-
est rates denominated in these currencies also incorporate substantive
sovereign risk premiums. The essence of the carry trade is that the in-
vestor bears pure foreign exchange risk, not sovereign risk. Furthermore,

7
Investable carry trade indices based on G10 currencies include the iPath Optimized
Currency Carry ETN and the Powershares DB G10 Currency Harvest Fund. The Bank for
International Settlements (2014) triennial survey reports that the G10 currencies accounted
for 88% of global foreign exchange market average daily turnover in April 2013. Academic
research that focuses on the profitability of carry trade strategies in the G10 currencies
includes Burnside et al. (2011a), Christiansen et al. (2011), Farhi et al. (2015), and Jurek
(2014).
12 Kent Daniel et al

Longstaff et al. (2011) demonstrate that sovereign risk premiums, as mea-


sured by credit default swaps (CDS), do not just measure idiosyncratic
sovereign default risk because the CDS returns covary positively with the
U.S. stock and high-yield credit markets. Thus, including emerging market
currencies could bias the analysis toward finding that the average returns
to the broadly defined carry trade are due to exposure to risks.
Our foreign currency options data are from J.P. Morgan.8 After evaluat-
ing the quality of the data, we decided that high quality, actively traded
data were only available from September 2000 to August 2013. We also
only have data for eight currencies versus the USD, as option data for the
SEK were not available.
We describe the data on various risk factors as they are introduced
below. Table A.1 in the online appendix provides distributional information
on the risk factors.

4 Returns and Risks of the Carry Trade

Table 1 reports basic unconditional sample statistics for the annualized


returns of our five dollar-based carry trade strategies. At each point in time,
the strategies are constructed using all G10 currencies for which data are
available.

4.1 Basic Carry Trade Statistics

Our first strategy, designated EQ, has equal absolute value weights. The
weight on currency j is therefore:
j
EQ si g n(i t − i t$ )
w j,t = (9)
Nt

where Nt is the number of currencies in our database at time t. Thus, if the


currency j interest rate is higher (lower) than the dollar interest rate, the
dollar-based investor goes long (short) $(1/Nt ) in the forward market of
currency j. This version of the carry trade is the most studied in academic
articles.9 The return to the EQ strategy from time t to time t + 1 is then
8
We thank Tracy Johnson at J.P. Morgan for her assistance in obtaining the data.
9
A partial list of studies that use an equally weighted strategy includes Bakshi and
Panayotov (2013), Bekaert and Panayotov (2015), Brunnermeier et al. (2008), Burnside
The Carry Trade: Risks and Drawdowns 13

Table 1: Summary statistics of USD carry trade returns


Description: This table presents summary statistics on returns to five carry trade strate-
gies: the basic equal-weighted (EQ) and spread-weighted (SPD) strategies, and their
risk-rebalanced versions (labeled “-RR”) as well as a mean-variance optimized strategy
(OPT). The risk-rebalanced strategies rescale the basic weights by IGARCH estimates of a
covariance matrix to target an annualized 5% standard deviation. The OPT strategy is a
conditional mean-variance efficient strategy at the beginning of each month, based on the
IGARCH conditional covariance matrix and the assumption that the expected future excess
currency return equals the interest rate differential. The sample period is 1976:02-2013:08
except for the AUD and the NZD, which start in October 1986. The reported parameters,
mean, standard deviation, skewness, excess kurtosis, and first-order autocorrelation, and
their associated standard errors are simultaneous GMM estimates. The Sharpe ratio is the
ratio of the annualized mean and standard deviation, and its standard error is calculated
using the delta method (see online appendix B).
Interpretation: Carry trade returns have statistically significant Sharpe ratios larger than
many other investments and exhibit negative skewness.
Carry Trade Weighting Method
EQ EQ-RR SPD SPD-RR OPT
Mean Ret (% p.a.) 3.96 5.44 6.60 6.18 2.10
(0.91) (1.13) (1.31) (1.09) (0.47)
Standard Deviation 5.06 5.90 7.62 6.08 2.62
(0.28) (0.22) (0.41) (0.24) (0.17)
Sharpe Ratio 0.78 0.92 0.87 1.02 0.80
(0.19) (0.20) (0.19) (0.19) (0.20)
Skewness -0.49 -0.37 -0.31 -0.44 -0.89
(0.21) (0.11) (0.19) (0.14) (0.34)
Excess Kurtosis 2.01 0.40 1.78 0.90 3.91
(0.53) (0.21) (0.35) (0.29) (1.22)
Autocorrelation 0.08 0.16 0.02 0.09 0.06
(0.07) (0.05) (0.07) (0.05) (0.07)
Max (% per month) 4.78 5.71 8.07 5.96 3.21
Min (% per month) -6.01 -4.90 -7.26 -5.88 -4.01
No. Positive 288 288 297 297 303
No. Negative 163 163 154 154 148
14 Kent Daniel et al

PNt EQ
the weighted sum of the returns: R EQ,t+1 = j=1 w j,t z j,t+1 where z j,t+1
is the time t + 1 payoff to investing $1 in the money market for foreign
currency j, and borrowing $1 at time t, which we implement using the
equivalent forward market transactions as discussed in Section 2.1.
The second strategy, labeled SPD, is ‘spread-weighted.’ Like the EQ
strategy, it is long (short) currencies that have a positive (negative) interest
differential relative to the dollar, but the size of the investment in a partic-
ular currency is determined by the relative magnitude of the interest-rate
differential:
j
i t − i t$
SPD
w j,t = N
Pt j
i t − i t$

j=1

The sum of absolute values of the weights in the foreign currencies is again
one, but the SPD strategy invests proportionately more in currencies that
have larger interest differentials.10
Because the return volatilities of the EQ and SPD strategies rise and fall
with changes in exchange rate volatilities, such strategies would not gener-
ally be employed by traders in FX markets who are typically constrained
by a value-at-risk requirement, defined as the maximum loss that could
be sustained with a given probability. For example, a typical value-at-risk
model constrains a trader to take positions such that the probability of
losing, say more than $1 million on any given day, is no larger than 1%.
Traders consequently must scale their investments based on some estimate
of portfolio risk. To evaluate the efficacy of such scaling we construct
“risk-rebalanced” versions of the EQ and SPD strategies, labeled EQ-RR and
SPD-RR.
Constructing these strategies requires a conditional covariance matrix
of the returns for which we use simple IGARCH models from daily data.
Let H t denote the conditional covariance matrix of returns at time t with
ij
typical element, h t , which denotes the conditional covariance between
the ith and jth currency returns realized at time t + 1. Then, the IGARCH

et al. (2011b), Clarida et al. (2009), Lettau et al. (2014), Lustig et al. (2011) and Lustig
et al. (2014).
10
Jurek (2014) spread weights by taking positions on the basis of the absolute distance
of country j’s interest rate from the average of the interest rates in countries with ranks
five and six.
The Carry Trade: Risks and Drawdowns 15

ij
model for h t is
ij j ij
h t = δ(r ti r t ) + (1 − δ)h t−1 (10)
where because of the daily horizon, we treat the product of the returns as
equivalent to the product of the innovations in the returns. We set δ = 0.06,
as suggested in J. P. Morgan (1996). To obtain the monthly covariance
matrix we multiply the daily IGARCH estimates of H t by 21.
For the EQ-RR p and SPD-RR strategies, we target a monthly standard
deviation of 5%/ 12 – corresponding to an approximate annualized stan-
dard deviation of 5% – by adjusting the dollar scale of the EQ and SPD
portfolios accordingly.
Our final strategy in this section involves sequential mean-variance
optimization and is labeled OPT. Beginning with the analysis of Meese and
Rogoff (1983), it is often argued that expected rates of currency apprecia-
tion are essentially unforecastable. Hence, we take the vector of interest
differentials, labeled µ t , to be the conditional means of the carry trade
returns, and we take positions wOP t
T
= κ t H t−1 µ t , where κ t is a scaling
factor that sets the sum of the absolute values of the weights equal to one
as in the EQ strategy. If the models of the
Æconditional moments are correct,
the conditional Sharpe ratio will equal µ0t H t−1 µ t .11
Table 1 reports the first four moments of the various carry trade strate-
gies and their (annualized) Sharpe ratios and first-order autocorrelations.
Standard errors are based on the Generalized Method of Moments of
Hansen (1982), as explained in Section B of the online appendix. Through-
out the paper, when we discuss estimated parameters, GMM standard errors,
calculated using three Newey and West (1987) lags, are in parentheses and
the associated robust t-statistics are in square brackets.
For the full sample, the carry trades for a USD-based investor have
statistically significant mean annual returns ranging from 2.10% (0.47)
for the OPT strategy, to 3.96% (0.91) for the EQ strategy, and to 6.60%
(1.31) for the SPD strategy. Jurek (2014) also finds that spread-weighting
improves the performance of the carry trades. The strategies have impres-
sive Sharpe ratios, which range from 0.78 (0.19) for the EQ strategy to
11
Ackermann et al. (2012) also use conditional mean variance modeling so their positions
are also proportional to H t−1 µ t , but they target a constant mean return of 5% per annum.
(0.05/12)
Hence, their positions satisfy wAPS t
= µ0 H −1 µ H t−1 µ t . While their conditional Sharpe ratio is
t t t
 0.5
also µ0t H t−1 µ t , their scaling factor responds more aggressively to perceived changes in
the conditional Sharpe ratio than ours.
16 Kent Daniel et al

1.02 (0.19) for the SPD-RR strategy. As Brunnermeier et al. (2008) note,
each of these strategies is significantly negatively skewed, with the OPT
strategy having the most negative skewness of -0.89 (0.34). Table 1 reports
positive excess kurtosis that is statistically significant for all strategies. The
first-order autocorrelations of the strategies are low, as would be expected
in currency markets, and only for the EQ-RR strategy can we reject that the
first-order autocorrelation is zero. Of course, it is well known that this test
has very low power against interesting alternatives. The minimum monthly
returns for the strategies are all quite large, ranging from -4.01% for the
OPT strategy to -7.26% for the SPD. The maximum monthly returns range
from 3.21% for the OPT to 8.07% for the SPD. Finally, Table 1 indicates
that the carry trade strategies are profitable on between 288 months for
the EQ strategy and 303 months for the OPT strategy out of the total of
451 months.12

4.2 Base Currency and Measurement Currency

The preceding discussion and most academic research about the carry trade
takes the perspective of a U.S.-based investor for whom the USD is, in our
terminology, both the base currency and the measurement currency. Here,
we use measurement currency to denote the currency in which the investor
measures his or her profits. The base currency denotes the currency which
is the basis for the positions that the carry trade takes.
For example, for the EQ strategy that is most often studied in the
academic literature, the USD is most often the base currency. The EQ
strategy goes goes long (short) all currencies with an interest rate higher
(lower) than the USD interest rate. Financing of the long high-interest-rate
currency positions is done by borrowing in USD, and the capital that is
raised by shorting the low-interest-rate currencies is assumed to be invested
in USD. Were such a strategy implemented in an alternative base currency,
the returns would be different for two reasons. First, the “cutoff-rate” that
determines whether a currency is bought or sold would be the base-currency
interest rate rather than the USD interest rate. Second, the financing of the
long positions and the investing from the short positions would be done in
the alternative base currency, rather than in USD. As as extreme example,
12
The strategy returns are all positively correlated. Correlations range from .63 for EQ
and OPT to .90 for EQ and SPD. The correlations of EQ and EQ-RR and SPD and SPD-RR
are .88 and .89, respectively.
The Carry Trade: Risks and Drawdowns 17

suppose the USD interest rate is the highest, and the JPY interest rate is
the lowest in the G-10. In this case, the USD-based EQ strategy would be
long 1 unit of USD, and short 1/9th of every other currency. The JPY-based
EQ strategy, in contrast, would be long only 1/9th unit of USD, and would
be short 1 unit of JPY.
The measurement currency for the EQ carry trade that is the basis for
most academic papers is also generally the USD. Note that the measurement
currency need not be the same as the base currency.13 For example, a
European investor could implement the EQ carry trade with a USD base
currency, but measure the returns in EUR. To do so, this investor would go
long (short) all currencies with an interest rate higher (lower) than the
USD interest rate, borrow in USD to finance the long (high-interest-rate)
currency positions, and invest the short proceeds (raised by shorting the
low-interest-rate currencies) in USD. However, this investor would measure
her profits in her EUR home currency.
One might imagine that the measurement currency would have a large
effect on the performance of the carry trade; to stick to our example
from the preceding paragraph with a USD base currency and an EUR
measurement currency, one might think that when the all other currencies
appreciate relative to the EUR, that EUR-measured carry trade return would
be substantively higher than the USD-measured return. Interestingly, this
effect is small, and it is vanishingly small in continuous time for diffusion
processes. The reason is that carry-trade returns are excess returns, and
to convert the payoffs measured in USD into EUR, you convert both the
long-side and the short-side payoffs. The result of a EUR depreciation over
an interval, for example, means that the EUR-measured long-side payoff
will be higher, but the EUR-measure short-side payoff will be lower by
roughly the same amount.
There is, however, a difference in average returns to these carry trades
from changing the measurement currency that arises as a result of any
covariance between the carry-trade return and the appreciation of the
measurement currency. We provide a mathematical derivation of this in
online appendix C, and confirm empirically that this covariance almost fully
captures the differences that arise from using an alternative measurement
currency. We also compare the results presented in Table 2, which are
denominated in USD, to results denominated in the base currency, and

13
We thank the editor, Ivo Welch, for pointing out this distinction.
18 Kent Daniel et al

verify that the performance ordering that we see in this table (both average
returns and Sharpe-ratios) is independent of the currency in which the
excess-returns are denominated.
While the measurement currency doesn’t affect our results, the choice
of base currency turns out to have a large effect. Table 2 presents the
summary statistics for EQ carry trades with alternative base currencies
but where, to allow for comparisons between the columns, the excess
returns are all measured in USD. For each strategy, if the interest rate in
currency j is higher (lower) than the interest rate of the base currency,
the investor goes long (short) in the forward market of currency j as in
the USD-based EQ strategy. For the non-USD-based currencies, the mean
annualized strategy returns range from 2.42% (1.26) for the CHF to 4.70%
(1.53) for the NZD. All mean returns are statistically significant at the .06
marginal level of significance or smaller. The USD-base-currency strategy
has the second highest mean return, but the highest Sharpe ratio among
these strategies.14 Despite their lower mean returns, the non-USD-based
strategies generally have higher volatilities, and as a results their Sharpe
ratios are all smaller than the USD-based Sharpe ratio of 0.78 (0.19).
Except for the EUR, the point estimates of skewness for the alternative
base-currency carry trades are all negative, and the statistical significance
of skewness is high for the JPY, NOK, SEK, CHF, NZD, and AUD. In addition,
the excess kurtosis of each strategy is positive and statistically significant.
Only the GBP-based carry trade shows any sign of first-order autocorrelation.
Only the return volatility of the CAD-based strategy is lower than the USD-
based one, and we thus find that the maximum gains and losses on these
strategies generally exceed those of the USD-based strategy with maximum
monthly losses for the JPY, SEK, CHF, NZD, and AUD carry trades exceeding
10%. The alternative base-currency carry trades also have fewer positive
monthly returns than does the USD-base strategy.15 These results show
that carry trade profitability is not just a USD phenomenon, but that the
USD is potentially more important than other currencies in determining
the profitability. We explore this in more depth below.

14
It is unlikely that we would be able to reject equivalence of the means, given the
standard errors.
15
For the NZD and AUD, for which the sample is smaller, the percentage of positive
monthly returns is slightly smaller than for the USD.
The Carry Trade: Risks and Drawdowns 19

Table 2: Summary Statistics of the EQ Carry Trade by Base Currency


Description: Each column of this table presents summary statistics on monthly excess
returns to the equal weight EQ carry trade strategy, for a given base currency. Each excess
return is dollar demoninated. The sample period is 1976:02-2013:08 except for the AUD and
the NZD, which start in October 1986. The reported mean, standard deviation, skewness,
excess kurtosis, and first-order autocorrelation, and their associated standard errors (in
parentheses) are simultaneous GMM estimates. The mean and standard deviation of the
monthly excess returns are annualized, and in percent. The Sharpe ratio is the ratio of the
annualized mean and standard deviation, and its standard error is calculated using the
delta method (see online appendix B).
Interpretation: The mean returns are statistically and economically large for every base
currency. The USD-base-currency strategy has the highest Sharpe ratio.
Carry Trade Base Currency
CAD EUR JPY NOK SEK CHF GBP NZD AUD USD
Mean Return 3.08 2.45 2.54 2.90 2.64 2.42 3.40 4.70 3.85 3.96
(0.74) (0.92) (1.79) (0.82) (0.97) (1.26) (0.97) (1.53) (1.40) (0.91)
Std. Dev. 4.24 5.30 9.77 5.02 5.61 7.26 5.59 8.36 7.48 5.06
(0.21) (0.26) (0.70) (0.29) (0.65) (0.43) (0.39) (0.82) (0.59) (0.28)
Sharpe Ratio 0.73 0.46 0.26 0.58 0.47 0.33 0.61 0.56 0.52 0.78
(0.18) (0.17) (0.19) (0.18) (0.21) (0.18) (0.18) (0.19) (0.20) (0.19)
Skewness -0.07 -0.02 -1.13 -0.42 -2.83 -0.69 0.10 -0.40 -0.63 -0.49
(0.19) (0.18) (0.42) (0.31) (0.84) (0.31) (0.50) (0.29) (0.25) (0.21)
Excess Kurtosis 1.49 1.25 4.98 2.81 20.46 2.79 4.80 4.48 2.96 2.01
(0.36) (0.39) (1.96) (0.86) (5.95) (1.17) (1.85) (1.17) (1.43) (0.53)
Autocorrelation 0.03 0.01 0.08 0.00 0.06 -0.02 0.09 -0.11 -0.08 0.08
(0.07) (0.06) (0.08) (0.06) (0.05) (0.06) (0.05) (0.10) (0.11) (0.07)
Max 4.71 6.05 8.75 6.55 5.42 8.49 9.78 10.02 7.86 4.78
Min. -4.20 -5.20 -17.29 -6.86 -13.89 -11.06 -8.12 -12.21 -11.04 -6.01
No. Positive 283 274 268 274 285 258 276 192 194 288
No. Negative 168 177 183 177 166 193 175 130 128 163
20 Kent Daniel et al

4.3 Carry-Trade Exposures to Risk Factors

We now examine whether the average returns to the dollar-based carry


trades described above can be explained by exposures to a variety of risk
factors. We include equity market, foreign exchange market, bond market,
and volatility risk factors. To measure risk exposures, we regress a carry
trade return, R t , on sources of risks, F t , as in

R t = α + β 0 Ft + "t . (11)

In most of our analysis we use market-traded risk factors that are returns
to zero-investment portfolios in which case α measures the average return
of the carry trade not explained by its unconditional exposure to the risks
included in the regression multiplied by the average returns to those risks.

4.3.1 Equity Market Risks

Panel A of Table 3 presents results for equity market risks represented by


the three Fama and French (1993) risk factors: the excess market return,
R m,t , as proxied by the return of the value-weighted portfolio of stocks on
the NYSE, AMEX, and NASDAQ markets over the one month T-bill return;
the return on a portfolio of small market capitalization stocks minus the
return on a portfolio of big stocks, RS M B,t ; and the return on a portfolio of
high book-to-market stocks minus the return on a portfolio of low book-to-
market stocks, R H M L,t .16 While eight of the 15 loadings on the risk factors
have t-statistics greater than 1.96, the R2 ’s are all small. Moreover, these
equity market risks leave most of the average returns of the carry trades
unexplained as the α’s range from 1.83% for the OPT strategy to 5.55%
for the SPD-RR strategy with all t-statistics larger than 3.72. These equity
market risks clearly do not explain average carry trade returns, consistent
with the analysis in Burnside et al. (2011b), among others.

4.3.2 Pure FX Risks

Panel B of Table 3 presents results for the two foreign exchange market
risks proposed by Lustig et al. (2011) who sort 35 currencies into six port-
folios based on their interest rates relative to the dollar interest rate, with
16
The Fama-French risk factors were obtained from Kenneth French’s web site which
also describes the construction of these portfolios.
The Carry Trade: Risks and Drawdowns 21

Table 3: Carry Trade Exposures to Equity, FX and Bond Risk Factors


Description: The Table presents regressions of returns to five carry trade strategies on the
three Fama and French (1993) equity market risk factors in Panel A, the two pure foreign
exchange risk factors constructed by Lustig et al. (2011) in Panel B, and the U.S. equity
market and two USD bond market risk factors in Panel C. The reported α’s are annualized
percentages. Autocorrelation and heteroskedasticity consistent t-statistics from GMM are
in square brackets.
Interpretation: The only insignificant α estimate in the Table is for the EQ portfolio with
the FX Factors of Lustig et al. (2011) as explanatory factors. However, the α’s remain
significant once the carry trade is either spread-weighted or risk-rebalanced.
Carry Trade Strategy
EQ SPD EQ-RR SPD-RR OPT
Panel A: Equity Factors, 1976:02-2013:08
α 3.39 5.34 4.95 5.55 1.83
[3.76] [4.00] [4.27] [4.84] [3.72]
βMKT 0.05 0.10 0.05 0.06 0.02
[2.46] [2.88] [2.25] [2.33] [1.88]
βSMB -0.03 0.00 -0.03 -0.01 0.01
[-0.90] [0.06] [-0.89] [-0.18] [0.96]
βHML 0.07 0.13 0.05 0.07 0.03
[2.21] [2.93] [1.62] [2.27] [1.98]
R2 .04 .05 .02 .02 .02
Panel B: FX Factors, 1983:11-2013:08
α 1.47 2.86 2.86 3.60 1.29
[1.73] [2.34] [2.81] [3.44] [2.87]
βRX 0.14 0.31 0.01 0.11 0.01
[2.27] [3.33] [0.24] [1.56] [0.45]
βHML−FX 0.28 0.39 0.34 0.32 0.09
[8.24] [7.04] [8.85] [6.57] [6.22]
R2 .31 .34 .29 .28 .13
Panel C: Bond Factors, 1976:01-2013:08
α 4.19 6.71 5.74 6.43 2.15
[4.51] [4.97] [5.03] [5.74] [4.65]
βMKT 0.04 0.08 0.04 0.04 0.02
[1.81] [2.36] [1.92] [2.01] [1.74]
β10y -0.39 -0.51 -0.44 -0.41 -0.12
[-2.97] [-2.72] [-4.25] [-3.74] [-2.97]
β10y−2y 0.46 0.59 0.50 0.47 0.14
[2.46] [2.21] [3.26] [2.93] [2.30]
R2 .05 .05 .05 .04 .02
22 Kent Daniel et al

portfolio one (six) containing the lowest (highest) interest rate currencies.
Their two risk factors are RRX ,t , the mean return on all six portfolios, and
R H M L−F X ,t , which is the return difference between portfolios 6 and 1. No-
tably, RRX ,t has a correlation of .99 with the first principal component of
the six portfolio returns, and R H M L−F X ,t has a correlation of .94 with the
second principal component.17 Given its construction, it is not surprising
that R H M L−F X ,t has significant explanatory power for our carry trade re-
turns, with t-statistics between 6.22 for the OPT portfolio and 8.85 for the
EQ-RR portfolio. The R2 ’s are also higher than with the equity risk factors,
ranging between .13 and .34. While this pure FX risk model better explains
the average returns to our strategies than do the equity risks, the α’s re-
main statistically significant and range from a low of 1.29% for the OPT
portfolio to 3.60% for the SPD-RR portfolio.18 While Lustig et al. (2011)
essentially demonstrate that the returns on their carry trade portfolios
have a reduced dimensionality, the conditioning information provided by
spread-weighting and risk-rebalancing allows those conditional trades to
demonstrate abnormal profits relative to that reduced factor space.

4.3.3 Bond Market Risks

Movements in exchange rates are relative rates of currency depreciation,


and in theory should reflect all sources of aggregate risks in the stochastic
discount factors associated with the two currencies. Because bond markets
explicitly price risks in the stochastic discount factor, it is logical that bond
market risk factors should also have explanatory power for the carry trade.19
Panel C of Table 3 presents the results of regressions of the carry trade
returns on the excess equity market return and two USD bond market risk
factors: the excess return on the 10-year bond over the one-month bill rate,
which represents the risk arising from changes in the level of interest rates,
and the difference in returns between the 10-year bond and the 2-year note,
which represents the risk arising from changes in the slope of the term
structure of interest rates. The bond market return data are from CRSP.

17
The factor return data are from Adrien Verdelhan’s web site, and the sample period is
1983:11-2013:08 for 358 observations.
18
Note however that the t-statistic of the α for the EQ portfolio falls to 1.73.
19
Sarno et al. (2012) find that reduced form affine models designed to price bond
yields, which have small bond pricing errors, are unable to capture the dynamics of the
rates of currency depreciation.
The Carry Trade: Risks and Drawdowns 23

The coefficients on both of the bond market factors are highly significant.
Positive returns on the 10-year bond that are matched by the return on the
2-year note, which would be caused by unanticipated decreases in the level
of the USD yield curve, are bad for the USD-based carry trades. Notice
also that the coefficients on the two excess bond returns are close to being
equal and opposite in sign, suggesting that unexpected positive returns on
the two-year note (i.e., decreases in the 2-year note yield) are bad for the
carry trades. Nevertheless, the R2 ’s remain between .02 and .05, as in the
equity market regressions. The statistically significant α’s, ranging from
2.15% for OPT to 6.71% for SPD, indicate that bond market risks do not
explain the carry trade returns.

4.3.4 Volatility Risk

To capture possible exposure of the carry trade to equity market volatility,


we introduce the return on an equity variance swap as a risk factor.20 This
return is calculated as
NX
d a ys  2 
Pt+1,d 252
‹
R V S,t+1 = ln − VIX2t ,
d=1
Pt+1,d−1 N d a ys

where N d a ys represents the number of trading days in a month and Pt+1,d


is the value of the S&P 500 index on day d of month t +1. The VIX data are
obtained from the CBOE web site. The availability of VIX data limits our
sample to 1990:02-2013:08 (283 monthly observations). Because R V S,t+1
is an excess return, we continue to examine the α’s to assess whether
exposure of the carry trade to volatility risk explains the average returns.
Table 4 presents regressions which incorporate the equity and bond
factors in addition to the variance swap returns. Because the sample period
here is different from the one in Table 3, we reproduce the regressions of
these two tables over this new sample period in the left panels, and then
add the volatility risk factors to these regression in the right panels.

20
Menkhoff et al. (2012) introduce foreign exchange volatility as a risk factor. To
develop a traded risk factor, they project FX volatility onto a set of currency returns sorted
on interest rate differentials. Because the resulting portfolio has a correlation of .80 with
R H M L−F X ,t , we find that their volatility risk factor has similar explanatory power to the pure
foreign exchange risk model described previously, and consequently, we do not report those
results here.
Table 4: Carry Trade Exposure to Equity and Volatility Risks 24
Description: This table reports regressions of five carry trade returns on risk factors as in Panels A and C of Table 3, but it also includes the
return on a variance swap as a risk factor. The sample period is 1990:02-2013:08 (283 observations). The reported α’s are annualized
percentages. Autocorrelation and heteroskedasticity consistent t-statistics from GMM are in square brackets.
Interpretation: The estimated α’s fall slightly and become statistically insignificant for the EQ and EQ-RR strategy after controlling for
exposure to both the bond-market factors and the variance swap returns. All other estimated α’s remain statistically significant.
EQ EQ-RR SPD SPD-RR OPT EQ EQ-RR SPD SPD-RR OPT
Panel A: Equity Risk Factors
α 3.11 4.15 4.51 4.54 1.38 2.87 3.76 4.22 4.20 1.32
[2.76] [2.50] [3.58] [3.34] [2.65] [2.56] [2.32] [3.41] [3.14] [2.40]
βMKT 0.09 0.16 0.06 0.07 0.03 0.08 0.15 0.05 0.06 0.02
[3.03] [3.66] [2.42] [2.66] [2.58] [2.42] [2.92] [1.81] [1.96] [1.98]
βSMB -0.04 -0.01 -0.04 -0.02 0.01 -0.04 -0.01 -0.04 -0.02 0.01
[-0.92] [-0.15] [-1.00] [-0.36] [1.01] [-0.97] [-0.22] [-1.08] [-0.45] [0.94]
βHML 0.06 0.14 0.04 0.07 0.03 0.06 0.13 0.04 0.06 0.03
[1.75] [2.77] [1.25] [1.99] [2.48] [1.60] [2.52] [1.11] [1.81] [2.37]
βVS -0.02 -0.03 -0.02 -0.03 -0.01
[-0.94] [-0.90] [-1.24] [-1.40] [-0.41]
R2 .07 .10 .04 .04 .04 .07 .11 .04 .05 .04
Panel B: Bond Risk Factors
α 2.83 3.77 4.75 4.71 1.60 2.32 2.79 4.38 4.13 1.45
[2.19] [2.08] [3.69] [3.43] [2.98] [1.72] [1.55] [3.40] [3.06] [2.61]
βMKT 0.07 0.15 0.05 0.06 0.02 0.06 0.12 0.04 0.04 0.02
[2.38] [3.05] [1.73] [2.11] [2.26] [1.85] [2.32] [1.27] [1.43] [1.59]
β10y 0.31 0.63 -0.07 0.08 -0.02 0.39 0.78 -0.01 0.16 0.01
[1.05] [1.57] [-0.26] [0.28] [-0.15] [1.26] [1.85] [-0.05] [0.58] [0.04]
β10y−2y -0.35 -0.73 0.08 -0.10 0.01 -0.44 -0.91 0.01 -0.20 -0.02
[-0.97] [-1.48] [0.24] [-0.29] [0.06] [-1.17] [-1.74] [0.03] [-0.59] [-0.13]
βVS -0.03 -0.06 -0.02 -0.04 -0.01
[-1.39] [-1.69] [-1.25] [-1.76] [-0.70]
Kent Daniel et al

R2 .04 .08 .02 .02 .02 .05 .09 .02 .03 .02
The Carry Trade: Risks and Drawdowns 25

In both Panels A and B of Table 4, the coefficients on R V S,t+1 are neg-


ative, indicating that carry trades perform badly when equity volatility
increases as stressed by Bhansali (2007) and Clarida et al. (2009). How-
ever, these slope coefficients are small and not statistically significant.
Moreover, exposure to volatility risk is not enough to explain the profitabil-
ity of the trades as the α’s are reduced only slightly and continue to remain
statistically significant.

5 Dollar Neutral and Pure Dollar Carry Trades

Lustig et al. (2014) and Jurek (2014) find important differences between
dollar-based carry trades and dollar-neutral carry trades. The analysis in
Section 4 confirms that the historical efficacy of the EQ carry trade depends
on the base currency in which it is implemented. In particular, Table 2 shows
that the USD-based EQ strategy had a higher Sharpe ratio than for any other
base currency. We now extend our earlier analysis by decomposing the EQ
portfolio into dollar-neutral and dollar-carry components. We confirm that
much of the efficacy of the carry trade is attributable to the dollar-carry
component, and we further demonstrate striking differences in the risk
characteristics of the two components.
Our dollar-neutral carry trade portfolio – which we label EQ-0$ – takes
positions only in the non-USD currencies. The EQ-0$ weights are:
1 j  k 
 + Nt if i t > med i t 

EQ−0$ j
w j,t = − 1 if i t < med i tk (12)
 Nt j  k 
0 if i t = med i t
 k
where med i t indicates the median of the non-USD interest rates at time
t, and Nt is the number of non-USD currencies in the sample at time t.
Then, assuming nine non-USD currencies, we take long positions of $(1/9)
in the four highest interest rate currencies, financed by short positions
of $(1/9) in the four lowest rate currencies. We take no position in the
median interest rate currency. Given this construction, EQ-0$ is a long-short
portfolio with no direct dollar exposure.
Tables 5 and 6 present summary statistics and analysis of the risk-
exposures of the EQ and EQ-0$ portfolios, and two additional portfolios
that capture the dollar component of the carry trade, which we describe in
Sections 5.1 and 5.2.
Table 5: Summary Statistics for the Dollar-Neutral and Pure-Dollar Carry Trades
Description: This table presents summary statistics on returns to four carry trade strategies. The first three are the equal-weighted (EQ), 26
dollar-neutral (EQ-0$) and dollar (EQ-$) strategies. EQ-$ is the difference between EQ and EQ-0$. EQ-D$ is the dynamic dollar strategy.
The sample period is 1976:02-2013:08 except for the AUD and the NZD, which start in October 1986. The reported parameters, mean,
standard deviation, skewness, excess kurtosis, and autocorrelation coefficient and their associated standard errors are simultaneous GMM
estimates, and the mean and standard deviation are annualized. The Sharpe ratio is the ratio of the annualized mean and standard
deviation, and its standard error is calculated using the delta method (see online appendix B). Panel A reports the results for the full
sample, while Panel B reports results for the sample 1990:02-2013:08 when variance swap data are available.
Interpretation: The dollar-neutral and dollar components of the EQ strategy, EQ-0$ and EQ-$, both have statistically significant mean
returns and Sharpe ratios, though the point estimates for the dollar component are slightly larger. The dynamic dollar strategy (EQ-D$) is
more volatile, but its Sharpe ratio is higher and skewness is lower than that of the EQ-$ strategy.
Panel A: 1976/02-2013/08 Panel B: 1990/2-2013/8
EQ EQ-0$ EQ-$ EQ-D$ EQ EQ-0$ EQ-$ EQ-D$
Mean Ret (% p.a.) 3.96 1.61 2.35 5.54 3.83 1.72 2.11 5.21
(0.91) (0.58) (0.66) (1.37) (1.17) (0.72) (0.92) (1.60)
Standard Deviation 5.06 3.28 3.85 8.18 5.43 3.30 4.31 7.89
(0.28) (0.16) (0.28) (0.38) (0.36) (0.21) (0.35) (0.47)
Sharpe Ratio 0.78 0.49 0.61 0.68 0.70 0.52 0.49 0.66
(0.19) (0.19) (0.18) (0.18) (0.24) (0.23) (0.23) (0.21)
Skewness -0.49 -0.47 -0.65 -0.11 -0.60 -0.47 -0.76 -0.05
(0.21) (0.19) (0.44) (0.17) (0.22) (0.28) (0.45) (0.22)
Excess Kurtosis 2.01 1.34 4.84 0.86 1.68 1.66 3.87 1.04
(0.53) (0.51) (2.00) (0.31) (0.57) (0.71) (1.86) (0.38)
Autocorrelation 0.08 0.05 0.05 0.00 0.05 0.05 0.05 -0.03
(0.07) (0.06) (0.06) (0.06) (0.08) (0.07) (0.06) (0.07)
Max (% per month) 4.78 3.28 3.83 9.03 4.60 3.28 3.80 9.03
Min (% per month) -6.01 -3.92 -6.69 -8.27 -6.01 -3.92 -6.69 -7.22
No. Positive 288 275 264 273 182 179 164 168
Kent Daniel et al

No. Negative 163 176 187 178 101 104 119 115
The Carry Trade: Risks and Drawdowns 27

Table 6: Dollar Neutral and Pure Dollar Carry Trade Risk Exposures
Description: Panels A, B and C present the results of regressions of carry trade returns
on the risk factors considered in Table 3. The reported α’s are annualized percentages.
Autocorrelation and heteroskedasticity consistent t-statistics from GMM are in square
brackets.
Interpretation: The dollar and dollar-neutral components of the EQ carry trade behave
very differently: the dollar-neutral component’s return is explained both by the equity
factors and the bond factors; the dollar component’s return is not. In particular, the
al pha’s of the dynamic-dollar strategy remain strongly statistically significant with all sets
of explanatory factors.
Carry Trade Strategy
EQ EQ-0$ EQ-$ EQ-D$
Panel A: Equity Factors, 1976:02-2013:08
α 3.39 1.03 2.36 5.41
[3.76] [1.54] [3.60] [3.70]
βMKT 0.05 0.08 -0.02 0.01
[2.46] [5.29] [-1.24] [0.21]
βSMB -0.03 0.02 -0.05 -0.05
[-0.90] [1.00] [-1.84] [-1.04]
βHML 0.07 0.05 0.02 0.06
[2.21] [2.83] [0.84] [1.08]
R2 .04 .10 .04 .01
Panel B: FX Factors, 1983:11-2013:08
α 1.47 -0.03 1.49 5.18
[1.73] [-0.06] [1.86] [3.40]
βRX 0.14 -0.02 0.15 0.52
[2.27] [-0.50] [2.80] [4.31]
βHML−FX 0.28 0.24 0.04 0.00
[8.24] [11.03] [1.58] [-0.01]
R2 .31 .41 .09 .20
Panel C: Bond Factors, 1976:01-2013:08
α 4.19 1.50 2.69 5.82
[4.51] [2.77] [3.88] [4.01]
βMKT 0.04 0.06 -0.03 -0.01
[1.81] [5.48] [-1.60] [-0.35]
β10y -0.39 -0.25 -0.14 -0.22
[-2.97] [-4.42] [-1.16] [-0.92]
β10y−2y 0.46 0.29 0.17 0.32
[2.46] [3.52] [1.02] [0.93]
R2 .05 .12 .02 .01
28 Kent Daniel et al

Table 7: Dynamic Dollar Strategy – Risk Factor Analysis


Description: This table presents regressions of the EQ-D$ returns on the full set of risk
factors, including the variance swap. The sample period is 1990:02-2013:08 (283 observa-
tions). The reported α is an annualized percentage. Autocorrelation and heteroskedasticity
consistent t-statistics from GMM are in square brackets.
Interpretation: The only factors to which the EQ-D$ strategy has statistically significant
exposures are the RX and variance swap returns. The α remains statistically significant
after controlling for these exposures.
α βMKT βSMB βHML β10y β10y−2y βRX βHML−FX βvs R2
coef. 4.52 0.02 -0.02 0.06 0.43 -0.57 0.44 0.14 0.13 .19
[2.79] [0.62] [-0.36] [1.15] [1.47] [-1.53] [3.14] [2.03] [2.67]

The second columns of Panels A and B of Table 5 report the first four
moments of the EQ-0$ portfolio returns as well as the Sharpe ratio and
the first-order autocorrelation. Panel A reports the full sample results, and
Panel B reports the results over the sample when VIX data are available.
For ease of comparison, we report the same set of statistics for the EQ
strategy in Column 1. The EQ-0$ portfolio has statistically significant mean
annual returns in both samples, 1.61% (0.58) for the full sample and 1.72%
(0.72) for the later sample. While these mean returns are lower than for
EQ strategy, the EQ-0$ volatility is also lower. However, the EQ-0$ Sharpe
ratios are nonetheless about 30% lower than the EQ Sharpe ratios in each
sample period. The negative skewness and insignificant autocorrelations of
the EQ-0$ strategy are comparable to those of the EQ strategy. Consistent
with the lower volatility, the maximum losses are smaller than those of the
EQ strategy. The next question is whether the EQ-0$ strategy is exposed to
risks.
The second column of Panels A and B in Table 6 shows that the alphas
of the EQ-0$ strategy are zero after controlling for either the three Fama
and French (1993) equity market risk factors, or the Lustig et al. (2014) FX
factors. Panel A shows that EQ-0$ loads significantly on the market return
and the HML factor, with t-statistics of 5.29 and 2.83, respectively. The
loading on the market return explains approximately 30% of the average
return, and the loading on the HML factor explains another 15% of the
average return. The resulting α has a t-statistic of 1.54, and the R2 is .10.
In comparison, the regression of EQ returns on the same equity risk factors
has an α of 3.39 with a t-statistic of 3.76 and an R2 of only .04. The
The Carry Trade: Risks and Drawdowns 29

Fama and French (1993) three factor model clearly does a better job of
explaining the average return of the EQ-0$ strategy than that of the EQ
strategy.
These results are consistent with Jurek (2014) who investigates a
shorter sample and finds marginally significant α’s in his spread-weighted
carry trade regressions when adding the Carhart (1997) momentum factor
to the three Fama and French (1993) model. He finds significant expo-
sures to the market return and HML, but smaller, insignificant α’s in his
spread-weighted, dollar-neutral, carry trade regressions on the same fac-
tors. These results suggest that, after eliminating the dollar exposure from
the EQ strategy, the average profitability of the developed currency carry
trade can be explained by commonly used equity risk factors.

5.1 A Decomposition of the Carry Trade

To better understand the performance difference between EQ and EQ-0$,


we create the EQ-$ portfolio, defined as the difference between the EQ and
the EQ-0$ portfolios:
EQ-$ EQ EQ-0$
w j,t ≡ w j,t − w j,t

where the weights on the EQ and EQ-0$ portfolios are given in equations
(9) and (12). Note that because both EQ and EQ-0$ are zero-investment
portfolios, EQ-$ is as well. The exact positions of the EQ-$ portfolio
depend on whether i t$ is below or above the median interest rate. If

i t$ < med ian i tk , then
 
j 

 0 if i t > med i tk 

 1 if i j = med i k
 

EQ-$ Nt t t
w j,t = 2 j 

 Ntif i t$ < i t < med i tk 

 j $

0 if i t ≤ i t
 


If i t$ > med ian i tk , then
 
j

 0 if i t > i t$ 

 − 1 if i j = med i k
 

EQ-$ Nt t
w j,t = 2
 k t j

 Nt
 if med i t < i t ≤ i t$ 

 j  
0 if i t ≤ med i tk
 
30 Kent Daniel et al

The EQ-0$ and EQ-$ portfolios decompose the EQ carry trade into two
components: a dollar-neutral component and a dollar component. EQ-$
goes long (short) the dollar when the dollar interest rate is higher (lower)
than the median interest rate but only against currencies with interest rates
between the median and dollar interest rates. Thus, if these interest rates
are close, the EQ-$ portfolio will be concentrated in just a few currencies.
The third columns of Panels A and B in Table 5 present the first four
moments of the EQ-$ strategy. The EQ-$ mean returns are statistically
significant in both samples, and the Sharpe ratios are close to those of the
EQ-0$ strategy. Skewness of EQ-$ is negative but statistically insignificant
due to the large standard error in both samples. In terms of both Sharpe
ratio and skewness, the EQ-$ strategy appears no better than the EQ-0$
strategy. Note also that the kurtosis of EQ-$ is far higher. Nevertheless, the
EQ-$ strategy has a correlation of -.11 with the EQ-0$ strategy, and the
following results illustrate that the EQ-$ strategy also differs significantly
from the EQ-0$ strategy in its risk exposures.
Column 3 of Panel A in Table 6 presents regressions of EQ-$ returns
on the three Fama and French (1993) risk factors. Unlike EQ-0$, only the
SMB factor shows any explanatory power for the EQ-$ returns. The α is
2.36% with a t-statistic of 3.60. The R2 is .04. The equity market risks
clearly do not explain the average returns to the EQ-$ strategy.
Columns 1 to 3 of Panel B in Table 6 present regressions of the returns
of EQ and its two components, EQ-0$ and EQ-$, on the two FX risk factors.
The two factor FX model completely explains the average returns of the
EQ-0$ strategy while explaining only 25% of the average returns of EQ-$.
The α for EQ-$ is also significant with a value of 1.49% and a t-statistic of
1.86 in the FX two factor model.
Finally, Columns 1 to 3 of Panel C in Table 6 present regressions of
the returns to the EQ strategy and its two components, EQ-0$ and EQ-
minus, on the equity market excess return and two bond market risk factors.
Similar to our previous findings, the market excess return and the bond
risk factors have significant explanatory power for the returns of EQ-0$
and a relatively high R2 of .12. By comparison, none of the risk factors has
any significant explanatory power for the returns on the EQ-$ strategy, and
the resulting R2 is only .02.
In summary, these results suggest that for the G10 currency dollar-based
carry trade, the conditional dollar exposure contributes more to the carry
trade “puzzle” than does the non-dollar component. This conclusion is
The Carry Trade: Risks and Drawdowns 31

consistent with the analysis of Lustig et al. (2014) who conclude that by
conditioning investments on the level of the average forward discount U.S.
investors earn large currency excess returns that are not correlated with
traditional carry trade returns.

5.2 The Dynamic Dollar Strategy

The EQ-$ strategy goes long (short) the dollar when the dollar interest rate
is above (below) the G10 median interest rate. It has the nice property of
complementing the EQ-0$ strategy to become the commonly studied equally
weighted carry trade EQ. However, as noted above, if the USD interest
rate is close to the median non-USD interest rate, EQ-$ takes positions in
relatively few currencies. Absence of diversification is consistent with the
large kurtosis noted in Table 5. Since the results just presented indicate
that the abnormal returns of EQ hinge on the conditional dollar exposure,
which is distinct from “carry,” we now expand the other leg of EQ-$ to
all foreign currencies. We define our diversified, dynamic dollar strategy,
EQ-D$, as:  1  
EQ-D$ + N if med i tk > i t$
w j,t =
− N1 if med i tk ≤ i t$
The EQ-D$ strategy focuses on the conditional exposure of the U.S. dollar.
It goes long (short) nine foreign currencies against the dollar when the
dollar interest rate is lower (higher) than the global median interest rate.
The EQ-D$ strategy is essentially the G10 counterpart of the “dollar carry"
strategy developed by Lustig et al. (2014) who take an equal weight long
(short) position in 20 developed currencies versus a short (long) position
in the dollar if the dollar interest rate is lower (higher) that the average
foreign interest rate.
The fourth columns of Panels A and B of Table 5 present the first four
moments of the returns to the EQ-D$ strategy for the full sample and the
VIX sample. We find that EQ-D$ has statistically significant mean annual
returns of 5.54% (1.37) for the full sample and 5.21% (1.60) for the VIX
sample, substantially higher than the means of EQ-$. Although its volatility
is also higher than the EQ-$ strategy, its Sharpe ratio of 0.68 (0.18) in
the full sample and 0.66 (0.21) in the VIX sample are larger although not
significantly different from those of the EQ-$ strategy. Skewness of the
EQ-D$ strategy is lower than the other three strategies and is statistically in-
significant in both periods. Also, consistent with the greater diversification
32 Kent Daniel et al

of EQ-D$, its excess kurtosis is lower, though still statistically significant.


Thus, the EQ-D$ strategy does not suffer from the extreme negative
skewness often mentioned as the hallmark of carry trades. In addition, the
fourth column of Table 6 reports regressions of the returns of EQ-D$ on
the three Fama and French (1993) equity market factors, the bond market
factors, and the FX risk factors. The only significant loading is on RRX ,t ,
which goes long all foreign currencies. The α’s range from 5.18% [t =
3.40] in the FX risks regression to 5.82% [t = 4.01] for the bond market
risks regression. When we use all of the risk factors simultaneously in
Table 7 for the shorter sample period, the foreign exchange risk factors
and the volatility factor have significant loadings, but the α of 4.52%
remains large and statistically significant. These findings are consistent
with those of Lustig et al. (2014) who report that their dollar-carry strategy
is unconditionally uncorrelated with the U.S. market return and their
R H M L−F X .
In summary, 60% of the premium earned by the EQ carry strategy can
be attributed to the EQ-$ component, but more importantly, the EQ-D$
portfolio built on this conditional dollar exposure earns a large premium
that is not explained by its small exposures to standard risk factors. Finally,
the insignificant negative skewness of the EQ-D$ portfolio returns indicates
that negative skewness does not explain the abnormal excess return of this
strategy.

6 Downside Risk and the Carry Trade

We turn now to the question of whether downside risk, defined as the


covariance of a return with the market return when the market return is
significantly negative, can explain the high average carry trade returns.
Lettau et al. (2014) and Jurek (2014) use different approaches to measure
downside risk, and both studies conclude that downside-risk explains the
average returns to the carry trade.21
We examine downside risk as an explanation for the carry trade pre-
mium through the lens of the return decomposition of the last section.
Consistent with the findings of Lettau et al. (2014) and Jurek (2014), we
21
Dobrynskaya (2014) uses a slightly different econometric specification than Lettau
et al. (2014) but reaches similar conclusions. We therefore focus our discussion only on
the latter.
The Carry Trade: Risks and Drawdowns 33

find that EQ-0$ exhibits considerable downside risk. However, consistent


with our findings with regard to other potential risk factors, we find that
EQ-$ and EQ-D$ exhibit no significant downside risk, and their high av-
erage returns remain high after these risk adjustments. Thus, it is the
dollar-neutral component of the carry trade that is exposed to downside
risk, even though the dollar-carry component is responsible for most of the
high average return earned by the carry trade.

6.1 The Lettau, Maggiori, and Weber (2014) Analysis

Lettau et al. (2014) note that although portfolios of high interest rate
currencies have higher exposures (β’s) to the market return than portfolios
of low interest rate currencies, the differences in unconditional market β’s,
combined with the average return to the market, prove to be insufficiently
large to explain the magnitude of average carry trade returns. However,
Lettau et al. (2014) further observe that the conditional exposures of carry
trade returns to the return on the market when it is down are larger than
their respective unconditional exposures. Based on this observation, they
explore the ability of the downside risk model of Ang et al. (2006) to explain
the high average carry trade returns.
In their empirical analysis, Lettau et al. (2014) define the downside
market return, which we denote R−m,t , as the market return when it is one
sample standard deviation below its sample mean and zero otherwise.22
They run OLS regressions of portfolio returns, R t , on a constant and either
R m,t or R−m,t to define the risk exposures, β and β − . From these risk
exposures, they argue that the expected return on a portfolio can be written
as
E(R t ) = β E(R m,t ) + (β − − β)λ−
where the sample mean return on the market is used for E(R m,t ) and the
price of downside risk, λ− , must be estimated in a cross-sectional regression
of average returns, adjusted for their unconditional exposure to the market,
on the beta differentials.23
22
We also considered two other definitions of R−m,t based on alternative definitions of
the downstate, either R m,t < R m , where R m is the sample mean, or R m,t < 0. These results
(in Table A.2 of the online appendix) are similar to the results reported here.
23
In this section, we follow the approach of Lettau et al. (2014) even though we agree
with Burnside and Graveline (2016), who are critical of this approach. Burnside and
Graveline (2016) note that this restricted two-beta representation of downside risk cannot
34 Kent Daniel et al

Lettau et al. (2014) work with 53 currency returns sorted into six
portfolios. They find that high interest rate differential portfolios have
slightly higher β’s than low interest rate differential portfolios, but these
differential market risks, when combined with the mean return on the
market are insufficient to explain the cross-sectional differences in the
average returns on the portfolios. Nevertheless, the point estimates of
β − −β are sufficiently monotonic that a cross-sectional regression of market-
adjusted average returns, from a variety of assets including currency returns,
on beta differentials produces a large price of downside risk, λ− . Based on
this Lettau et al. (2014) conclude that the average returns on the currency
portfolios are explained by the downside risk model.
To examine this possible explanation of our carry trade returns, we
first run two univariate regressions where the dependent variable is a carry
trade return:
Rt = α + βR m,t + e t
R−t = α− + β − R−m,t + e−
t

The first regression uses all of the data; the second uses data only when
the market return is in the downstate. The downside risk theory requires
that β − be different from β. Hence, as a first step, we explicitly test the
difference between β − and β with a χ 2 (1) constructed from GMM using
Newey and West (1987) standard errors with three lags. Table 8 presents
the results for our eight carry trade portfolios.
In the basic regressions in Panel A we find estimates of unconditional
β’s that are quite small, ranging from -0.03 for the EQ-$ portfolio to 0.07
for the SPD portfolio. Only the β’s of the EQ-0$ and the SPD portfolios
are significantly different from 0 at the .05 marginal level of significance.
The EQ-$ and EQ-D$ strategies, on the other hand, have slightly negative
β’s, which are statistically insignificantly different from 0. Because the
risk factor in these first regressions is an excess return, the α’s can be
interpreted as average abnormal returns, and all of the α’s except the EQ-
0$ are strongly significantly different from zero, as the smallest Newey-West
t-statistic is 3.78.
Panel B of Table 8 examines the downside regression. The estimates of

β are also small, ranging from -0.14 for EQ-D$ to 0.15 for SPD. These
be derived from a stochastic discount factor (SDF) model that has the properties that one
would want to impose, including that the SDF is monotonically decreasing as R m,t crosses
the boundary from the down state into the up state.
The Carry Trade: Risks and Drawdowns 35

Table 8: Carry Trade Exposures to Downside Market Risk


Description: This table presents analysis of the downside market risk explanation of the
carry trade premium offered by Lettau et al. (2014). Panel A presents estimated coefficients
and GMM-based standard errors for the monthly regression

R t = α + β · R m,t + ε t ,

where R m,t is the CRSP value-weighted market return minus the one-month Treasury bill
return. Panel B presents results from the same regression, but where the sample includes
only months for which the excess market return R m,t was at least one sample standard
deviation below its sample mean. Panel B also reports the χ 2 (1) statistic that tests the
difference in the two slope coefficients (i.e., β and β − ), and the p-value associated with
that χ 2 statistic. Panel C calculates β − − β and uses estimates of downside risk premiums,
λ− ’s, from Lettau et al. (2014) to calculate expected returns on the carry trades from the
downside risk model. The sample period is 1976:02-2013:08 (451 observations). The α
estimates in Panels A and B and the premium estimates in Panel C are annualized, and
GMM-based autocorrelation and heteroskedasticity consistent t-statistics are given in square
brackets.
Interpretation: Strikingly, the estimates of the downside beta (β − ) and the unconditional
beta (β) are almost equal, and the p-value associated with the χ 2 statistic shows that they
are not statistically different. Panel C shows that the estimated magnitudes of the downside
risk premia are small (using either value of λ− ) compared with the estimated premium
presented in Panel A.
Panel A: EQ SPD EQ-RR SPD-RR OPT EQ-0$ EQ-$ EQ-D$
α 3.72 6.08 5.18 5.92 1.98 1.18 2.54 5.63
[4.01] [4.55] [4.50] [5.30] [4.12] [2.06] [3.78] [4.03]
β 0.03 0.07 0.04 0.04 0.02 0.06 -0.03 -0.01
[1.55] [2.13] [1.59] [1.71] [1.51] [4.78] [-1.68] [-0.36]

Panel B: EQ SPD EQ-RR SPD-RR OPT EQ-0$ EQ-$ EQ-D$


α− 2.82 13.21 4.19 14.05 1.49 6.79 -3.97 -4.50
[0.48] [1.78] [0.45] [2.10] [0.44] [1.84] [-0.83] [-0.45]
β− 0.03 0.15 0.05 0.14 0.02 0.13 -0.10 -0.14
[0.53] [1.92] [0.42] [1.74] [0.41] [3.07] [-1.83] [-1.22]
χ 2 (1) 0.00 1.06 0.01 1.96 0.00 3.59 1.97 1.42
p-value 1.00 0.30 0.92 0.16 0.98 0.06 0.16 0.23

Panel C: EQ SPD EQ-RR SPD-RR OPT EQ-0$ EQ-$ EQ-D$


β − -β 0.00 0.08 0.01 0.10 0.00 0.07 -0.07 -0.13
Downside Risk Premium(β −− β) × λ−
λ− = 16.9 0.00 1.31 0.16 1.63 0.01 1.22 -1.22 -2.21
λ− = 26.2 0.00 2.02 0.25 2.53 0.02 1.89 -1.89 -3.28
36 Kent Daniel et al

estimates are either equal to or only slightly larger, in absolute value, than
the corresponding β estimates. The standard errors of the estimates of β −
are sufficiently large that the largest t-statistic, other than for the EQ-0$
portfolio, is only 1.92, which coincides with a marginal level of significance
of .03. The p-values of the tests of the equality of β − and β are all larger
than .16, except for the EQ-0$ portfolio where we can reject the null
hypothesis at the .06 marginal level of significance. Notice also that the
negative estimate of β − for the EQ-D$ strategy indicates that this strategy is
inversely exposed to the market’s downside risk.24 Rather than concluding
that this downside risk model cannot explain our carry trade returns, we
confront our portfolio returns and the estimates of their risk exposures
with the prices of downside risk estimated by Lettau et al. (2014).
Because R−m,t is not a return, one cannot interpret the constants in
these regressions as abnormal returns, which is why Lettau et al. (2014)
perform a cross-sectional analysis of market-adjusted average returns on
risk exposures to estimate the additional price of downside market risk.
To determine how much our estimated exposures to downside risk could
possibly explain the average returns to our carry trades, we combine our
point estimates of β − − β with the point estimates of the price of downside
risk from Lettau et al. (2014), rather than performing our own cross-
sectional analysis on a small number of assets. Lettau et al. (2014) include
assets other than currencies in their cross-sectional analysis and find large
positive prices of downside market risk, depending on the cross-section of
assets included. When they include currencies and equities with returns
measured in percentage points per month, they estimate λ− = 1.41%, or
16.9% per annum. When they include only currencies, they estimate λ−
= 2.18%, or 26.2% per annum. The last two rows of Panel C in Table
8 multiply our estimates of β − − β by either 16.9% or 26.2%. Doing so
provides the explained part of our average carry trade returns that is due to
downside risk exposure. Compared to the α’s in Panel A, the extra return
24
Because the EQ-D$ strategy takes positions in all foreign currencies relative to the
USD based only on the position of the USD interest rate relative to the median interest rate,
it is not strictly a carry trade, and the return on the portfolio when the market is down
could be driven by movements in currencies whose interest rates are more extreme relative
to the median than the dollar interest rate. For example, if the USD interest rate is below
the median interest rate but above the JPY interest rate, the EQ-D$ strategy will go long
the JPY, which could massively appreciate in a market crash as carry trades unwind leading
to a large gain for the EQ-D$ strategy whereas the carry trade strategy would have shorted
the JPY and would have experienced a large loss when the market crashed.
The Carry Trade: Risks and Drawdowns 37

explained by downside risk exposure is minimal for the EQ, EQ-RR, and
OPT strategies. The downside risk premium explains between 0% and
10% of the CAPM α’s of these three strategies. For the SPD and SPD-RR
strategies, the downside risk premium explains between 21.5% and 42.7%
of the CAPM α’s. Notice also that the negative estimate of β − for the EQ-D$
strategy implies that the downside market risk theory cannot explain the
excess return of the EQ-D$ strategy as the additional expected return from
downside risk exposure is actually -2.12% or -3.28%, depending on the
value of λ− .
As a check on the sensitivity of our conclusions about the inability of
downside risk to explain the carry trade, we redo the above downside risk
analysis using the five interest rate sorted portfolios of Lettau et al. (2014).
Portfolio P1 (P5) contains the lowest (highest) interest rate currencies. The
results presented in Table 9 have the same format as Table 8.
Panel A of Table 9 demonstrates that the β’s of these portfolios are
also small, but they are monotonically increasing from 0.01 for P1 to 0.10
for P5. The CAPM α’s are also monotonically increasing from -1.77% [-
1.17] for P1 to 3.27% [1.73] for P5. While these α’s are not particularly
statistically significant, the P5−P1 portfolio has an α of 5.04% with a t-
statistic of 3.76. Panel B of Table 9 shows that the point estimates of β −
also monotonically increase from 0.01 for P1 to 0.22 for P5, but these five
estimates are insignificantly different from zero as the largest t-statistic
is 1.23. The p-values of the tests of the equality of β − to β for the five
portfolios are all larger than .43, and the test for the P5−P1 portfolio has a
.29 marginal level of significance. Although we do not find significant beta
differentials in Panel B, we again combine the point estimates of β − − β
with the estimated prices of downside risk from Lettau et al. (2014), as
above. Panel C of Table 9 shows that the predicted downside risk premiums
are not monotonically increasing from P1 to P5. The P1 portfolio has a
larger downside risk premium than the P2 and P3 portfolios, even though
the CAPM α of the P1 portfolio is -1.77% and the CAPM α’s of the P2 and
P3 portfolios are -0.69% and 0.96%, respectively. Nevertheless, we note
that 36% or 57% of the CAPM α of the P5−P1 portfolio can be explained
by the difference between the downside beta and the unconditional beta
using the point estimates of the annualized downside risk premium of
16.9% or 26.2%. Overall, these results highlight our concerns that the
downside betas are not reliably different from standard betas, and the
resulting differences in the two betas are not sufficiently large to account
38 Kent Daniel et al

Table 9: LMW Portfolios – Exposure to Downside Market Risk


Description: This table presents an analysis of the downside market risk explanation of
carry trade returns offered by Lettau et al. (2014) using their developed country portfolio
returns. The five portfolios contain currency returns from low interest rate countries in
P1 to high interest rate countries in P5. The calculations in Panels A, B and C follow the
description given in Table 8.
Interpretation: This table again shows that the estimated downside risk betas are close to
the unconditional betas. Particularly for the low interest-rate-currency portfolio (P1) and
for the difference portfolio, the magnitudes of the estimated downside risk premiums are
small relative to the size of the premiums.

Panel A: P1 P2 P3 P4 P5 P5-P1
α -1.77 -0.69 0.96 2.15 3.27 5.04
[-1.17] [-0.40] [0.58] [1.35] [1.73] [3.76]
β 0.01 0.05 0.05 0.06 0.11 0.10
[0.29] [1.29] [1.31] [1.72] [2.20] [3.08]

Panel B: P1 P2 P3 P4 P5 P5-P1
α− 1.16 -3.71 1.88 11.93 14.08 12.92
[0.08] [-0.26] [0.12] [1.02] [0.73] [1.27]
β− 0.01 0.02 0.05 0.15 0.22 0.21
[0.08] [0.15] [0.29] [1.23] [1.00] [1.89]
χ 2 (1) 0.00 0.03 0.00 0.62 0.32 1.11
p-value 0.99 0.85 0.99 0.43 0.57 0.29

Panel C: P1 P2 P3 P4 P5 P5-P1
β −− β 0.00 -0.02 -0.00 0.09 0.11 0.11
Downside Risk Premium β −− β × λ−


λ− = 16.9 0.03 -0.41 -0.03 1.45 1.82 1.79


λ− = 26.2 0.05 -0.63 -0.05 2.25 2.83 2.78
The Carry Trade: Risks and Drawdowns 39

for the average returns to carry trade portfolios, even allowing for very
large downside-risk prices.

6.2 The Jurek (2014) Downside Risk Analysis

Jurek (2014) examines the exposure of carry trades to downside risk by


regressing carry trade returns on a downside risk index (DRI), defined to be
the monthly return from a zero-investment, levered portfolio that sells S&P
500 puts with an average maturity of six weeks. The DRI is developed and
explored in Jurek and Stafford (2015), who argue that it can be thought of
as a straightforward way to express downside risk, and that the average
return to the DRI can therefore be considered to be a risk premium. Jurek
and Stafford (2015) show that an appropriately levered investment in
selling puts accurately matches the pre-fee risks and returns of broad hedge
fund indices such as the HFRI Fund-Weighted Composite and the Credit
Suisse Broad Hedge Fund Index.25 Because the DRI is an excess return, this
approach to downside risk has the advantage that the estimated regression
intercept can be interpreted as a measure of abnormal returns with respect
to the traded risk factor.
Our analysis uses DRI returns from January 1990 to August 2013.26
Table A.1 in the online appendix presents summary statistics for the DRI
returns over this sample period. The mean return is an annualized 9.42%,
which is highly statistically significant given its standard error of 1.43%.
The DRI is also highly non-normally distributed as evidenced by its skewness
of -2.92, its excess kurtosis of 13.57, and the fact that the excess return to
the DRI is positive in more that 82% of the months of our sample period.
Jurek (2014) examines monthly regressions of spread-weighted and
spread-weighted/dollar-neutral carry trades over the 1990:1-2012:06 pe-
riod, and he reports slope coefficients [OLS t-statistics] on the DRI of
0.3514 [6.41] and 0.3250 [5.85], respectively, and α’s of 0.0019 [0.14]
and -0.0032 [-0.22], respectively. Jurek (2014) interprets the strong signif-
icance of the slopes and the fact that the α’s are economically small and
25
Caballero and Doyle (2012) use the return from shorting VIX futures as an indicator
of systemic risk to explain the carry trade. Because VIX futures only began trading in 2004,
we focus here on the DRI.
26
We are grateful to Jakub Jurek for providing the DRI returns used in Jurek (2014).
His data are constructed by splicing data from the Berkeley Options Database (1990:01-
1996:12) with data from OptionMetrics (1996:01-2012:06). We use OptionMetrics data to
extend the DRI returns to August 2013.
40 Kent Daniel et al

statistically insignificant as evidence that this measure of downside risk


explains the average returns of the carry trades quite well.
Panel A of Table 10 presents the results of regressing the monthly
returns to our carry trade portfolios on the DRI returns. For the EQ, SPD,
EQ-RR, SPD-RR and OPT portfolios our results are consistent with Jurek’s
findings, in that the slope coefficients on the DRI return are statistically
significant.27 However, in contrast with Jurek’s findings, the α’s remain
mostly statistically significant. The key reason for this difference is revealed
in the last three portfolios: for the EQ-0$ (dollar-neutral) portfolio the slope
coefficient is highly statistically significant (t = 5.14), and the t-statistic of
the α is only 0.13, consistent with Jurek’s finding that the returns of the
carry trade portfolio are explained by its exposure to the DRI. In contrast
to Jurek’s results, though, for the EQ-$ and the EQ-D$ portfolios, the point
estimates of the slope coefficients on DRI are actually negative (though
statistically insignificant), and the α for the EQ-D$ portfolio remains large
and statistically significant.
Differences in the findings on the first five portfolios arise from differ-
ences in portfolio construction. Jurek (2014) defines the spread as the
absolute distance between country i’s interest rate and the average of the
interest rates on the fifth and sixth of the G10 countries while we define
the spread as the absolute distance between country i’s interest rate and
the USD interest rate. As a result, our spread-weighted carry trade has
more exposure to the USD than the comparable portfolio in Jurek (2014).
This evidence is again consistent with the hypothesis that, while the
dollar-neutral component of our carry trades is exposed to downside risk,
the dollar component has no significant exposure, and its premium remains
strong after controlling for its exposure to downside risk in the form of the
Jurek and Stafford (2015) DRI.
In Panel B, we include the DRI with the three Fama and French (1993)
risk factors as regressors. Here, we find that none of the slope coefficients
on DRI is significantly different from zero, and the α’s all retain their
magnitude and statistical significance, with the exception of the dollar-
neutral EQ-0$ strategy. These findings reinforce the conclusion that the
high returns of the dynamic dollar strategy cannot be explained by exposure
27
Our robust t-statistics are not as large as those reported in Jurek (2014), who reports
OLS results. In unreported results, we find that OLS t-statistics are larger, and approxi-
mately equal to Jurek’s. We think OLS t-statistics are inappropriate given the conditional
heteroskedasticity in the data.
The Carry Trade: Risks and Drawdowns 41

Table 10: Carry Trade Exposure to the Downside Risk Index


Description: This table presents regressions of carry trade returns on the downside risk
index (DRI) derived by Jurek and Stafford (2015) in Panel A. Panel B augments the Panel A
regression with the three Fama-French risk factors. The sample period is 1990:01-2013:07
(283 observations). The reported α’s are annualized percentages. Autocorrelation and
heteroskedasticity consistent t-statistics from GMM are in square brackets.
Interpretation: The downside risk index does a good job explaining the returns of the
dollar-neutral-carry portfolio, but it still fails to explain the premium associated with the
dollar carry portfolios.

Panel A: EQ SPD EQ-RR SPD-RR OPT EQ-0$ EQ-$ EQ-D$


α 2.59 3.22 4.18 4.07 1.26 0.10 2.49 5.37
[2.05] [1.74] [2.99] [2.67] [2.17] [0.13] [2.39] [2.83]
β DRI 0.14 0.28 0.10 0.13 0.05 0.18 -0.04 -0.01
[2.45] [2.90] [1.89] [2.36] [2.26] [5.14] [-0.76] [-0.11]
R2 .03 .06 .02 .03 .02 .14 .00 .00

Panel B: EQ SPD EQ-RR SPD-RR OPT EQ-0$ EQ-$ EQ-D$


α 2.90 3.70 4.33 4.09 1.22 0.45 2.45 6.07
[2.31] [1.98] [3.04] [2.60] [2.08] [0.51] [2.33] [3.05]
β DRI 0.05 0.09 0.05 0.08 0.03 0.09 -0.04 -0.19
[0.64] [0.79] [0.73] [1.08] [0.85] [1.49] [-0.53] [-1.33]
βMKT 0.07 0.13 0.04 0.04 0.02 0.05 0.01 0.11
[1.63] [2.07] [1.04] [1.01] [0.99] [2.54] [0.41] [1.86]
βSMB -0.04 -0.01 -0.04 -0.01 0.01 0.01 -0.05 -0.04
[-0.90] [-0.13] [-0.99] [-0.33] [1.05] [0.74] [-1.48] [-0.71]
βHML 0.06 0.13 0.04 0.06 0.03 0.03 0.03 0.07
[1.68] [2.65] [1.16] [1.89] [2.41] [1.85] [0.96] [1.18]
R2 .06 .10 .03 .04 .04 .17 .03 .02
42 Kent Daniel et al

to the DRI.

7 Analysis of the Hedged Carry Trade

We now analyze the returns of hedged carry trade strategies: specifically,


we supplement the EQ, SPD, and EQ-D$ portfolios examined earlier with
positions in currency options so as to protect these strategies against large
losses, as described in Section 2.3. The sample period is from September
2000 to August 2013. Jurek (2014) utilizes a full set of 45 bilateral put
and call currency options for the G10 currencies, and he notes correctly
that using only put and call options versus the USD overstates the cost of
hedging because it does not take advantage of directly hedging bilateral
non-USD exposure with the appropriate bilateral option for which the
volatility of the non-USD cross-rate and hence the costs of the options are
lower. We simply do not have the data to implement this more efficient
approach to hedging. Thus, the changes in profitability in going from our
unhedged strategies to the hedged strategies overstate the reductions in
profitability that traders would actually have experienced.
Table 11 reports the results for the hedged carry trades. For comparison,
the statistics for the corresponding unhedged EQ, SPD and EQ-D$ carry
trades over the same sample are reported in the first three columns of
the table. The first thing to notice is that, in this shorter sample, the
profitability of the unhedged carry trades is not as large as in the full
sample. The annualized mean returns (standard errors) are only 2.22%
(1.43) for the EQ strategy, 5.55% (2.50) for the SPD strategy, and 4.58%
(2.27) for the EQ-D$ strategy. The Sharpe ratios are also slightly lower at
0.47 (0.31), 0.66 (0.31), and 0.53 (0.26), respectively, and they are less
precisely estimated than in the longer sample. While the point estimates
of unconditional skewness of the unhedged EQ and SPD strategies remain
negative, they are insignificantly different from zero. Skewness of the
EQ-D$ strategy is positive but insignificantly different from zero.
The average returns for the hedged carry trades are reported for 10∆
and 25∆ option strategies. In each case, the average hedged returns are
lower than the corresponding average unhedged returns. For the 10∆
(25∆) strategies, the average profitabilities of the hedged EQ, SPD and
EQ-D$ strategies are 38 (87), 34 (129), and 61 (145) basis points less than
their respective unhedged counterparts. Also, the statistical significance
The Carry Trade: Risks and Drawdowns 43

Table 11: Hedged Carry Trade Performance


Description: This table presents summary statistics for the currency-hedged carry trades
for the EQ, SPD, and EQ-D$ strategies. The sample period is 2000:10-2013:08. The
sample includes G10 currencies other than Swedish krona, for which we do not have
option data. The reported parameters (mean, standard deviation, skewness, excess kurtosis,
and autocorrelation coefficient) and their associated standard errors are simultaneous
GMM estimates. The Sharpe ratio is the ratio of the annualized mean and standard
deviation, and its standard error is calculated using the delta method (see online appendix
B). The hedging strategy is described in Section 2.3. Autocorrelation and heteroskedasticity
consistent standard errors from GMM are in parentheses.
Interpretation: The mean returns associated with the three carry-trade portfolios become
slightly smaller once the returns are hedged. The Sharpe ratios are very similar.
EQ SPD EQ-D$ EQ SPD EQ-D$
Unhedged 10∆ 25∆ 10∆ 25∆ 10∆ 25∆
Mean Ret (% p.a.) 2.22 5.55 4.58 1.84 1.35 5.21 4.26 3.97 3.13
(1.43) (2.50) (2.27) (1.22) (1.05) (2.19) (1.87) (2.07) (1.81)
Standard Dev. 4.75 8.39 8.59 4.32 3.96 7.53 6.65 7.95 7.07
(0.38) (0.79) (0.66) (0.32) (0.31) (0.69) (0.62) (0.61) (0.61)
Sharpe Ratio 0.47 0.66 0.53 0.42 0.34 0.69 0.64 0.50 0.44
(0.31) (0.31) (0.26) (0.29) (0.26) (0.29) (0.27) (0.25) (0.24)
Skewness -0.32 -0.23 0.20 0.02 0.27 0.28 0.70 0.54 0.93
(0.20) (0.28) (0.26) (0.19) (0.27) (0.25) (0.26) (0.23) (0.23)
Excess Kurtosis 0.71 1.88 0.84 0.36 0.65 1.40 1.54 0.65 1.22
(0.43) (0.60) (0.42) (0.33) (0.40) (0.57) (0.60) (0.53) (0.87)
Autocorrelation 0.01 0.02 -0.11 -0.07 -0.13 -0.02 -0.07 -0.13 -0.16
(0.12) (0.11) (0.08) (0.10) (0.10) (0.10) (0.09) (0.09) (0.10)
Max (%) 4.04 8.01 8.83 3.75 3.48 7.67 7.01 8.56 8.44
Min (%) -4.12 -7.44 -7.15 -2.93 -3.52 -6.30 -4.75 -5.30 -3.68
No. Positive 93 99 85 94 86 97 91 84 76
No. Negative 62 56 70 61 69 58 64 71 79
44 Kent Daniel et al

of the average returns of the hedged EQ strategies is questionable, as the


p-values of the hedged EQ strategies increase from .12 for the unhedged
to .132 and .198 for the 10∆ and 25∆ trades, respectively. On the other
hand, the p-values of the 10∆ and 25∆ hedged SPD strategies remain quite
low, at .017 and .022, respectively. Hedging the EQ-D$ strategy causes a
slight deterioration in the statistical significance of the mean return as the
p-values of the hedged EQ-D$ strategies rise from the .043 of the unhedged
to .055 and .083 for the 10∆ and 25∆ trades, respectively.
In comparing the maximum losses across the unhedged and hedged
strategies, notice that hedging provides only limited protection against
substantive losses for the EQ and SPD strategies: the maximum monthly
loss for the EQ strategy is 4.12%, compared to maximum losses for the 10∆
and 25∆ hedged strategies of 2.93% and 3.52%, respectively. Similarly, the
maximum monthly unhedged loss for the SPD strategy is 7.44%, and the
maximum losses for the 10∆ and 25∆ hedged SPD strategies are 6.30%
and 4.75%, respectively. Hedging the EQ-D$ strategy does help to avoid a
substantive loss: the maximum losses are 5.30% and 3.68% for the 10∆
and 25∆ hedged strategies, compared to 7.15% for the unhedged EQ-D$
strategy.

7.1 Risk Exposures of the Hedged Carry Trades

We now examine whether risk exposures of the different versions of the


unhedged and hedged carry trades for the shorter sample period can explain
their average returns. Panel A of Table 12 examines exposures to the three
Fama and French (1993) factors in Panel A, and we add the return on the
variance swap in Panel B. For the shorter sample, the α for the unhedged
EQ strategy is 1.80% with a t-statistic of 1.55 and a corresponding p-value
of .12. There is strong statistically significant exposure to the market return,
and the R2 is .20.28 The corresponding results for the SPD strategy also
indicate stronger and statistically more significant exposures to the market
return and the HML factor than in the full sample, as well as a higher R2

The exposure to the market in the shorter sample, β̂MKT = 0.13 [5.26], is substantively
28

larger than the estimate for the full sample, 0.05 [2.46]. An anonymous referee suggests
that the stronger relation between carry trade returns and market returns in this post-
2000 sub-sample is consistent with increased synchronization across different markets,
particularly since the financial crisis. We leave an investigation of this very interesting
phenomenon to future research.
The Carry Trade: Risks and Drawdowns 45

of .26. Nevertheless, the α of the SPD strategy remains important and


statistically significant at 4.23% [2.13] . Hedging these carry trades does not
have a large effect on the magnitude or statistical significance of the results
as the α’s in the EQ-10∆ and EQ-25∆ strategies are both smaller with
smaller t-statistics while the α’s in the SPD-10∆ and SPD-25∆ strategies
are only slightly smaller and remain statistically significant. The exposures
to the market return and HML also remain statistically significant for the
hedged SPD strategy.
Both the hedged and unhedged EQ-D$ strategies have no statistically
significant exposure to the Fama and French (1993) factors in the shorter
sample, and although the α’s remain relatively large, they are statistically
insignificant at the .10 marginal level of significance. Panel B of Table 12
adds the return to the variance swap as a risk factor to the equity risks.
With the equity market factors, the return to the variance swap only has
explanatory power for the EQ-D$ strategy where it is statistically significant
for both the unhedged and hedged returns. The positive coefficients on
the variance swap return indicate that the EQ-D$ strategy does well when
the equity market becomes more volatile. The addition of the variance
swap with its negative price of risk raises the α’s in these regressions and
increases the t-statistics such that they are now statistically different from
zero at the .035 marginal level of significance.
Panel A of Table 13 considers exposures to the equity market excess
return and the two bond market excess returns as in Table 6. We see sig-
nificant differences between the shorter sample results and the full sample
results for all three strategies. For the EQ carry trade, the significance of
the bond market factors in the full sample is now gone, while the return on
the equity market is strong, as was just reported. For the SPD strategy, the
bond market factors are now statistically significant as before, but the signs
of the coefficients are opposite to those estimated from the full sample.
Hedging these two carry trades causes very little change in the slope
coefficients or the t-statistics but reduces the magnitude of the α’s, none of
which has a t-statistic larger than 1.57. For the EQ-D$ strategy, the bond
market risk factors are statistically significant and nearly equal and opposite
in sign indicating that a positive two-year bond return is associated with
a positive return to the strategy. Notice, though, that the estimated slope
coefficients on the bond market returns are opposite in sign from those for
the full sample. Panel B of Table 13 adds the return to the variance swap as
a risk factor to the bond risks. In conjunction with the bond market factors,
46 Kent Daniel et al

Table 12: Hedged Carry Trade Exposure to Equity Risks


Description: This table presents regressions of the hedged carry trade returns of the EQ,
SPD, and EQ-D$ strategies on the three Fama and French (1993) risk factors in Panel A.
The second regression specification includes the return on a variance swap in Panel B. The
sample period is 2000:10-2013:08 (155 observations) and includes G10 currencies other
than the Swedish krona, for which we do not have option data. Results for unhedged
returns over the same sample are also reported. The α’s are annualized percentages.
Autocorrelation and heteroskedasticity consistent t-statistics from GMM are in square
brackets.
Interpretation: Over this shorter time period for which we have option data, the α’s for
the carry strategies are smaller. Hedging the tail risk using 10 Delta and 25 Delta options
reduces the α’s just slightly. The α’s of the SPD strategy remain statistically significant,
even over the shorter sample, after hedging tail risk, and controlling for the variance-swap
return.
Panel A: Unhedged 10∆ 25∆ 10∆ 25∆ 10∆ 25∆
EQ SPD EQ-D$ EQ SPD EQ-D$
α 1.80 4.23 3.88 1.45 1.01 3.95 3.18 3.29 2.54
[1.55] [2.13] [1.72] [1.43] [1.10] [2.23] [2.04] [1.60] [1.41]
βMKT 0.13 0.26 0.07 0.11 0.09 0.23 0.18 0.07 0.05
[5.26] [4.99] [1.05] [5.00] [3.71] [4.92] [4.20] [1.00] [0.81]
βSMB 0.00 -0.02 0.04 0.01 0.01 -0.01 0.00 0.04 0.04
[-0.00] [-0.35] [0.57] [0.15] [0.25] [-0.12] [0.01] [0.57] [0.59]
βHML 0.03 0.14 0.08 0.03 0.03 0.13 0.11 0.08 0.07
[1.17] [3.14] [1.18] [1.11] [1.17] [3.19] [3.27] [1.27] [1.32]
R2 .20 .26 .03 .18 .13 .26 .22 .03 .03
Panel B: Unhedged 10∆ 25∆ 10∆ 25∆ 10∆ 25∆
EQ SPD EQ-D$ EQ SPD EQ-D$
α 1.58 4.07 4.76 1.43 1.15 3.92 3.30 4.17 3.39
[1.42] [2.07] [2.10] [1.42] [1.24] [2.22] [2.08] [2.02] [1.89]
βMKT 0.12 0.25 0.14 0.11 0.10 0.22 0.19 0.13 0.11
[3.74] [3.96] [2.20] [3.95] [3.72] [4.08] [3.85] [2.24] [2.21]
βSMB -0.01 -0.03 0.06 0.01 0.01 -0.01 0.00 0.06 0.06
[-0.12] [-0.41] [0.80] [0.13] [0.34] [-0.14] [0.07] [0.82] [0.88]
βHML 0.03 0.14 0.10 0.03 0.03 0.13 0.12 0.10 0.09
[0.99] [3.01] [1.56] [1.08] [1.32] [3.13] [3.39] [1.69] [1.80]
βVS -0.03 -0.02 0.11 0.00 0.02 0.00 0.01 0.11 0.10
[-1.30] [-0.45] [2.10] [-0.11] [0.74] [-0.09] [0.37] [2.18] [2.29]
R2 .21 .26 .07 .18 .14 .26 .22 .08 .08
The Carry Trade: Risks and Drawdowns 47

Table 13: Hedged Carry Trade Exposure to Bond Risks


Description: This table presents regressions of the hedged carry trade returns of EQ, SPD,
and EQ-D$ strategies on the excess return on the U.S. equity market and two EQ-D$ bond
market risk factors: the excess return on the 10-year Treasury bond; and the excess return
of the 10-year bond over the two-year Treasury not in Panel A. The second regressions in
Panel B include the return on a variance swap. The sample period is 2000:10-2013:08 (155
observations) and includes G10 currencies other than the Swedish krona, for which we do
not have option data. Results for unhedged returns over the same sample are also reported.
The α’s are annualized percentages. Autocorrelation and heteroskedasticity consistent
t-statistics from GMM are in square brackets.
Interpretation: Over this shorter 2000:10-2013:08 time period for which we have option
data, the α’s for the carry strategies are smaller and are all statistically insignificant at
conventional levels. Hedging the tail risk using 10 Delta and 25 Delta options reduces the
α’s just slightly. Controlling for the variance-swap return doesn’t affect this conclusion.
Panel A: Unhedged 10∆ 25∆ 10∆ 25∆ 10∆ 25∆
EQ SPD EQ-D$ EQ SPD EQ-D$
α 1.51 3.00 2.13 1.09 0.60 2.80 2.11 1.67 1.15
[1.22] [1.44] [0.95] [1.03] [0.66] [1.57] [1.42] [0.82] [0.66]
βMKT 0.14 0.30 0.13 0.13 0.10 0.27 0.22 0.12 0.09
[4.85] [5.14] [1.89] [4.71] [4.07] [5.13] [4.74] [1.84] [1.64]
β10y 0.16 0.99 1.47 0.24 0.36 0.96 0.99 1.39 1.27
[0.56] [2.12] [2.36] [0.90] [1.47] [2.23] [2.66] [2.39] [2.49]
β10y−2y -0.10 -0.96 -1.61 -0.21 -0.38 -0.94 -1.04 -1.52 -1.43
[-0.30] [-1.76] [-2.11] [-0.66] [-1.24] [-1.87] [-2.29] [-2.12] [-2.20]
R2 .21 .27 .08 .19 .14 .27 .24 .08 .08
Panel B: Unhedged 10∆ 25∆ 10∆ 25∆ 10∆ 25∆
EQ SPD EQ-D$ EQ SPD EQ-D$
α 1.15 2.46 3.14 1.01 0.71 2.48 1.98 2.68 2.14
[0.97] [1.27] [1.39] [0.97] [0.79] [1.49] [1.39] [1.32] [1.23]
βMKT 0.13 0.27 0.18 0.12 0.11 0.25 0.21 0.17 0.14
[3.71] [3.92] [2.55] [4.01] [3.86] [4.01] [3.82] [2.56] [2.51]
β10y 0.24 1.11 1.25 0.26 0.33 1.03 1.02 1.17 1.05
[0.83] [2.39] [2.29] [0.95] [1.39] [2.39] [2.75] [2.36] [2.51]
β10y−2y -0.21 -1.11 -1.32 -0.23 -0.34 -1.03 -1.08 -1.23 -1.15
[-0.60] [-2.04] [-2.04] [-0.71] [-1.17] [-2.03] [-2.39] [-2.10] [-2.26]
βV S -0.03 -0.04 0.08 -0.01 0.01 -0.02 -0.01 0.08 0.08
[-1.45] [-0.97] [1.53] [-0.27] [0.40] [-0.61] [-0.26] [1.59] [1.70]
R2 .22 .27 .10 .19 .14 .27 .24 .10 .10
48 Kent Daniel et al

the return to the variance swap only has explanatory power for the hedged
EQ-D$ strategies, and the α’s have reduced statistical significance. Given
the substantive differences between the coefficient estimates in the shorter
sample versus the full sample, we are unwilling to conclude that bond
market risk factors have unconditional ability to explain the unhedged and
the hedged returns to the EQ-D$ strategy.
Table 14 demonstrates that the downside risk indicator (DRI) of Jurek
and Stafford (2015) has strong significance for the EQ and SPD strategies,
both in their unhedged and hedged forms, for the shorter sample. The slope
coefficients are statistically significant, and the α’s are also insignificantly
different from zero indicating that the DRI alone has the power to explain
these carry trades. Consistent with our findings (with a longer sample) in
Section 6.2, the DRI has no ability to explain the unhedged EQ-D$ strategy
as the slope coefficient is essentially zero leaving an α of 4.58%, albeit with
a t-statistic that has a p-value of just .10. The DRI has no ability to explain
the return to the hedged EQ-D$ strategy either, and the α’s remain large
with t-statistics that are marginally significant at the .10 level. Consistent
with our findings for the unhedged strategies, the dynamic dollar strategy
does not appear to be unconditionally significantly exposed to any of the
proposed risk factors, despite its high average returns.

8 Drawdown Analysis

Carry trades are generally found to have negative skewness. The literature
has associated this negative skewness with crash risk. However, negative
skewness at the monthly level can stem from extreme negatively skewed
daily returns or from a sequence of persistent, negative daily returns that
are not negatively skewed. These two cases have different implications
for risk management and for theoretical explanations of the carry trade.
If persistent negative returns are the explanation, the early detection of
increased serial dependence could potentially be used to limit losses. While
the literature has almost exclusively focused on the characteristics of carry
trade returns at the monthly frequency, we now characterize the downside
risks of carry trade returns at the daily frequency while retaining the
monthly decision interval.29
29
While traders in foreign exchange markets can easily adjust their carry trade strategies
at the daily frequency, or even intraday, with minimal transaction costs, we choose to
The Carry Trade: Risks and Drawdowns 49

Table 14: Hedged Carry Trade Exposure to the Downside Risk Index
Description: This table presents regressions of the hedged carry trade returns of EQ, SPD,
and EQ-D$ strategies on the downside risk index (DRI) reported by Jurek and Stafford
(2015). The sample period is 2000:10-2013:08 (155 observations) and includes G10
currencies other than Swedish krona, for which we do not have option data. Results
for unhedged returns over the same sample are also reported. The α’s are annualized
percentages. Autocorrelation and heteroskedasticity consistent t-statistics from GMM are
in square brackets.
Interpretation: Over this shorter time period for which we have option data, the EQ and
SPD strategies have a statistically significant exposure to the DRI returns. This is not
affected by hedging with currency options. However, DRI has no ability to explain the
EQ-D$ strategy returns, before or after hedging.
Unhedged 10∆ 25∆ 10∆ 25∆ 10∆ 25∆
EQ SPD EQ-D$ EQ SPD EQ-D$
α 0.12 1.73 4.58 0.31 0.51 2.15 2.18 4.21 3.72
[0.10] [0.75] [1.66] [0.28] [0.48] [1.09] [1.28] [1.66] [1.65]
βDRI 0.25 0.45 0.03 0.19 0.11 0.37 0.26 0.01 -0.03
[4.97] [3.40] [0.20] [3.54] [1.94] [3.17] [2.41] [0.04] [-0.25]
R2 .16 .16 .00 .11 .05 .14 .09 .00 .00

To calculate daily returns for a monthly carry trade strategy, we consider


a trader that has one dollar of capital deposited in the bank at the end
of month t −1. The trader earns the one-month dollar interest rate, i t$ ,
prorated per day. We assume traders borrow and lend at the prorated one
month euro-currency interest rates, and we infer foreign interest rates from
the USD interest rate and covered interest rate parity. At time t −1, the
trader also enters one of the five carry trade strategies, EQ, EQ-RR, SPD,
SPD-RR, or EQ-D$, which are rebalanced at the end of month t. Let Pt,τ
represent the cumulative carry trade profit realized on day τ during month

t. The accrued interest on the one dollar of committed capital is 1 + i t$ Dt
by the τ th trading day of month t with Dt being the number of trading
days within the month. The excess daily return can then be calculated as
follows:

examine the daily returns to carry trades that are rebalanced monthly to maintain consis-
tency with the academic literature and because we do not have quotes on forward rates for
arbitrary maturities that are necessary to close out positions within the month.
50 Kent Daniel et al

  Dτ 
Pt,τ + 1 + i t$ t
 D1
r x t,τ = τ−1
− 1 + i t$ t

1 + i t$

Pt,τ−1 + Dt

Panel A of Table 15 shows summary statistics of these daily returns from


the five strategies. The daily returns are annualized for ease of comparison
to the corresponding annualized monthly returns in Panel B. If the daily
returns were independently and identically distributed, the annualized
moments at the daily and monthly levels would scale such that with 21
trading days in a month, the means and standard deviations
p would be the
same. Standardized daily skewness would be the 21 = 4.58 times the
standardized monthly skewness, and standardized daily kurtosis would be
21 times the standardized monthly kurtosis. For ease of comparison, Panel
C presents the ratios of monthly central moments to daily central moments,
where the ratios are normalized by their values under the i.i.d. assumption,
in which case each of the normalized ratios would equal 1.
A comparison of Panels A and B shows that the annualized daily mean
returns for the five strategies are within seven basis points of their annual-
ized monthly counterparts. The annualized daily standard deviations are
all just slightly below the annualized monthly standard deviations, which is
consistent with the return processes having small positive autocorrelations
at the daily frequency. Given that the means and standard deviations match
quite well, the annualized Sharpe ratios of the daily and monthly series
are also essentially the same.
In contrast with the first two moments, the higher moments of the five
strategies show considerable differences across their daily and monthly
values. The most extreme result is for the EQ-D$ portfolio where the
difference in skewness between the daily value of 0.01 and the monthly
value of -0.11 leads to a large standardized ratio of -51.2. The ratios of
standardized monthly skewness to daily skewness for the EQ and SPD
portfolios are 7.1 and 2.4, respectively, indicating that the skewness of
the monthly returns is far more negative than what it would be if the
daily returns were i.i.d.. On the other hand, the same ratios for the EQ-
RR portfolio of 1.7 and the SPD-RR portfolio of 1.3 are markedly closer
to 1. This is not surprising because risk rebalancing targets a constant
predicted variance, which reduces the serial dependence in the conditional
variance of the return. As a result, the data generating processes of the risk
Table 15: Summary Statistics of Daily Carry Trade Returns
Description: This table reports summary statistics on the daily returns for five carry trade strategies in Panel A and monthly returns in
Panel B. The sample period is 1976:02-2013:08. The reported parameters, (mean, standard deviation, skewness, excess kurtosis, and
autocorrelation coefficient) and their associated standard errors are simultaneous GMM estimates. The Sharpe ratio is the ratio of the
annualized mean and standard deviation, and its standard error is calculated using the delta method (see Appendix B). The maximum
and minimum daily and monthly returns are not annualized. Panel C examines the ratios of the monthly central moments to the daily
central moments and normalizes these ratios by the expected ratios if daily returns were i.i.d. Hence, if daily returns were indeed i.i.d., the
normalized ratios would be approximately 1.
Interpretation: Comparing the estimates of skewness and excess kurtosis in Panel A with those presented in Panel B, after normalizing,
as we do in Panel C, shows that the high levels of skewness and kurtosis for the monthly returns are inconsistent with the daily returns
being i.i.d.

Panel A: Daily Carry Trade Returns Panel B: Monthly Carry Trade Returns
EQ EQ-RR SPD SPD-RR EQ-D$ EQ EQ-RR SPD SPD-RR EQ-D$
Mean Ret (% p.a.) 3.92 5.38 6.53 6.13 5.47 3.96 5.44 6.60 6.18 5.54
(0.82) (0.91) (1.18) (0.93) (1.25) (0.91) (1.13) (1.31) (1.09) (1.37)
The Carry Trade: Risks and Drawdowns

Standard Dev. 5.06 5.54 7.25 5.65 7.68 5.06 5.90 7.62 6.08 8.18
(0.10) (0.11) (0.15) (0.15) (0.11) (0.28) (0.22) (0.41) (0.24) (0.38)
Sharpe Ratio 0.77 0.97 0.90 1.08 0.71 0.78 0.92 0.87 1.02 0.68
(0.17) (0.17) (0.17) (0.18) (0.16) (0.19) (0.20) (0.19) (0.19) (0.18)
Skewness -0.32 -1.01 -0.59 -1.62 0.01 -0.49 -0.37 -0.31 -0.44 -0.11
(0.17) (0.43) (0.33) (0.71) (0.15) (0.21) (0.11) (0.19) (0.14) (0.17)
Excess Kurt. 7.46 11.90 10.25 24.43 4.66 2.01 0.40 1.78 0.90 0.86
(1.16) (6.61) (4.05) (12.02) (1.22) (0.53) (0.21) (0.35) (0.29) (0.31)
Autocorr. 0.03 0.02 0.02 0.02 0.01 0.08 0.16 0.02 0.09 0.00
(0.02) (0.01) (0.01) (0.01) (0.01) (0.07) (0.05) (0.07) (0.05) (0.06)
Max (%) 3.12 2.13 4.52 2.58 5.08 4.78 5.71 8.07 5.96 9.03
Min (% ) -2.78 -5.64 -6.57 -6.61 -3.71 -6.01 -4.90 -7.26 -5.88 -8.27
No. Positive 5230 5230 5223 5223 4988 288 288 297 297 273
No. Negative 4342 4342 4349 4349 4584 163 163 154 154 178
Panel C: Normalized Ratios of Higher Central Moments
EQ EQ-RR SPD SPD-RR EQ-D$
Mean Ret (% p.a.) 1.0 1.0 1.0 1.0 1.0
51

Standard Deviation 1.0 0.9 1.0 0.9 0.9


Sharpe Ratio 1.0 1.1 1.0 1.1 1.1
Skewness 7.1 1.7 2.4 1.3 -51.2
Kurtosis 5.7 0.7 3.7 0.8 3.9
52 Kent Daniel et al

rebalanced portfolios conform better to the i.i.d. assumption. The values of


daily skewness for the EQ-RR and SPD-RR strategies do reveal substantive
negative values of -1.01 and -1.62, respectively. Similarly, normalized
ratios between the monthly and daily values of kurtosis are far above
the value implied by the i.i.d. assumption for the EQ, SPD, and EQ-D$
portfolios, whereas the same ratios for the EQ-RR and SPD-RR portfolios
are again much closer to 1. Lastly, the minimum (actual, not annualized)
daily returns are of similar size to the minimum (actual, not annualized)
monthly returns for all five strategies. In this sense, it may seem that much
of the risk of the carry trade is realized at the daily level, yet the months
with the largest daily losses are not the months with the largest monthly
losses.
We now use two measures to characterize the downside risks of the
carry trades. Consistent with the literature, we define a drawdown as the
percentage loss from the previous high-water mark to the following lowest
point. The pure drawdown measure of Sornette (2003) is the percentage
loss from consecutive daily negative returns. We rank the drawdowns
from most extreme to least extreme, and we compare these empirical
distributions to those generated by simulating daily excess returns of the
five strategies from counterfactual models under the assumption that the
returns are independent across time using independent bootstrapping with
replacement. This approach allows for non-normality in the data but retains
the independence of daily innovations.30 We simulate 10,000 trials of the
same number of daily observations as the actual data, and we calculate the
probability (reported as a p-value) of observing the empirical patterns in
the simulations.

8.1 Drawdowns

Panel A of Table 16 reports the magnitudes (labeled “Mag.”) of the 10


worst drawdowns, their p-values (labeled “p-b”) under the bootstrap simu-
lations, and the number of days (labeled “days”) over which that particular
drawdown occurred. In thinking about the p-values, it is important to re-
member that we are doing multiple comparisons, and while we will discuss

30
Chernov et al. (2016) use historical currency return processes and option data to
estimate stochastic volatility jump-diffusion models. We have not attempted to simulate
from these more realistic but decidedly more complex models to generate distributions of
drawdowns and maximum losses.
The Carry Trade: Risks and Drawdowns 53

the individual p-values, we want to be conservative in assessing whether


the strategies deviate significantly from the i.i.d. bootstrap distributions.
Because we are examining 10 drawdowns, we will use the Bonferroni
bound, dividing the marginal significance level for our joint hypothesis test,
of say .05, by 10. Hence, observing a p-value of .005 for any one of the
drawdowns allows us to conclude that the simulation model is rejected
at the .05 level. The smallest p-values for the five strategies are .005 for
the EQ, .002 for the SPD, .009 for the EQ-RR, .021 for the SPD-RR, and
.004 for the EQ-D$. Thus, we can be reasonably confident that the i.i.d.
bootstrap distributions do not characterize the data generating processes.
The worst drawdown from the EQ strategy is 12.0%. This corresponds
to a p-value of .13, indicating that the probability of observing one draw-
down worse than 12.0% is not inconsistent with the i.i.d. bootstrap. This
large drawdown was not a crash, though, as it took 93 days to go from
the peak to trough. The second through fourth worst EQ drawdowns are
10.8%, 9.6%, and 7.8%, and their p-values indicate that the probabilities
of observing the same or larger number of drawdowns worse than those
magnitudes is less than 2% under the bootstrap. Therefore, while a sin-
gle worst drawdown of 12.0% is not unlikely under the assumptions of
the simulated distributions, for less extreme but still severe drawdowns,
the EQ strategy suffers such drawdowns more frequently than the i.i.d.
distributions suggest. Each of the 10 worst drawdowns of the EQ strategy
occurred over at least 21 days with 3 taking more than 100 days.
For the SPD strategy, the worst drawdown is 21.5%, which corresponds
to a p-value of .023 for the bootstrap distribution. This worst drawdown
occurred over a 162 day period. The SPD strategy experienced 10 draw-
downs with magnitudes greater than 8.2%, which is a very unlikely event in
the simulations as the p-value of the tenth drawdown is .002. The number
of days it took to experience each of the 10 worst drawdowns also exceeds
50. Risk-rebalancing has a minimal effect on the drawdowns of the EQ
strategy as it slightly increases the magnitude of seven of the 10 largest,
while risk rebalancing the SPD strategy cuts the largest drawdown in half.
The distributions of drawdowns for the EQ-RR and SPD-RR strategies often
reach p-values below .05, but risk rebalancing does raise the Bonferroni
bounds from 5% and 2% for the EQ and SPD strategies, respectively, to 9%
and 21% for the risk rebalanced versions. Risk rebalancing also tends to
lengthen the period over which the maximum drawdowns are experienced
because rebounds tend to occur in high volatility periods.
Table 16: Drawdowns and Pure Drawdowns
Description: This table examines the distributions of the drawdowns of five carry trade strategies under bootstrap simulations. Data 54
include the magnitude (labeled Mag.) of the drawdown, the p-value (labeled “p-b”) from the simulated distribution, and the number of
“days” over which that drawdown occurred. The strategies are the basic equal-weighted (EQ) and spread-weighted (SPD) strategies, their
risk-rebalanced versions (labeled -RR), and the dynamic dollar strategy (EQ-D$). The sample period is 1976:02-2013:08 except for the
AUD and the NZD, which start in October 1986.
Interpretation: the low p-values that come from the bootstrap simulation show that the large drawdowns that we observe are inconsistent
with daily returns being drawn from an i.i.d. distribution.
EQ SPD EQ-RR SPD-RR EQ-D$
Panel A: Worst 10 Drawdowns
N Mag. p-b days Mag. p-b days Mag. p-b days Mag. p-b days Mag. p-b days
1 12.0% 13.0% 93 21.5% 2.3% 162 14.1% 6.4% 352 10.2% 40.3% 68 17.4% 25.0% 114
2 10.8% 1.8% 106 13.2% 9.8% 59 10.5% 4.9% 339 9.7% 14.3% 339 12.6% 35.3% 633
3 9.6% 0.5% 97 9.5% 46.0% 133 9.0% 3.6% 68 8.4% 13.4% 79 12.1% 15.7% 106
4 7.8% 1.4% 111 9.4% 21.8% 95 8.6% 0.9% 304 7.6% 13.4% 67 11.0% 13.2% 51
5 5.8% 24.0% 36 9.4% 8.9% 50 7.8% 1.1% 67 7.2% 8.8% 61 10.9% 3.7% 499
6 5.2% 36.0% 21 9.0% 5.1% 61 6.6% 5.3% 52 7.1% 3.2% 113 10.5% 2.1% 69
7 5.2% 19.6% 48 8.9% 1.9% 37 6.5% 2.6% 97 6.7% 2.6% 95 9.6% 2.9% 97
8 4.9% 22.3% 31 8.4% 2.0% 304 5.6% 13.5% 59 6.4% 2.1% 17 9.3% 1.1% 36
9 4.8% 12.0% 77 8.2% 0.9% 66 5.5% 6.9% 36 5.8% 3.8% 5 9.3% 0.4% 129
10 4.7% 8.1% 135 8.2% 0.2% 64 5.5% 2.9% 5 5.6% 2.5% 1 8.8% 0.4% 122
Panel B: Worst 10 Pure Drawdowns
N Mag. p-b days Mag. p-b days Mag. p-b days Mag. p-b days Mag. p-b days
1 5.2% 1.4% 6 7.3% 19.1% 6 5.6% 57.9% 1 6.6% 61.3% 1 5.7% 23.2% 4
2 4.4% 0.5% 11 6.9% 6.4% 6 5.5% 28.3% 5 5.8% 44.0% 5 5.0% 21.7% 6
3 3.8% 0.5% 4 6.5% 5.9% 1 4.6% 14.4% 7 5.6% 29.0% 1 4.6% 18.3% 10
4 3.8% 0.1% 5 6.2% 2.4% 5 4.1% 13.1% 7 4.5% 27.3% 5 4.1% 44.8% 4
5 3.5% 0.1% 4 5.8% 0.7% 7 3.7% 14.3% 7 4.2% 22.1% 7 4.1% 27.1% 2
6 3.5% 0.0% 2 4.8% 0.8% 8 3.7% 6.6% 5 3.7% 14.7% 5 4.0% 17.9% 5
7 3.3% 0.0% 3 4.7% 0.3% 5 3.3% 9.3% 1 3.6% 8.2% 6 4.0% 11.0% 3
8 3.2% 0.0% 7 4.6% 0.1% 3 3.3% 4.6% 6 3.5% 4.5% 9 3.9% 9.8% 6
Kent Daniel et al

9 3.2% 0.0% 6 4.4% 0.1% 7 3.1% 4.9% 4 3.4% 2.3% 7 3.9% 5.6% 4
10 3.1% 0.0% 7 4.4% 0.0% 3 3.0% 4.3% 4 3.2% 1.8% 6 3.9% 3.2% 10
The Carry Trade: Risks and Drawdowns 55

The maximum drawdown of the EQ-D$ strategy is 17.4%, which oc-


curred over 114 days. With a p-value of .25, this is not a particularly
anomalous event in the simulations. Nevertheless, the 10-th worst draw-
down was 8.8%, which occurred over 122 days, and observing 10 or more
drawdowns of this magnitude in the simulations has a p-value of .004.
Consequently, we can reject the i.i.d. bootstrap distribution for this strategy
at the .04 marginal level of significance.

8.2 Pure Drawdowns

Panel B of Table 16 reports the magnitudes (labeled Mag.) of the 10


worst pure drawdowns, their p-values (labeled “p-b”) under the bootstrap
simulations, and the number of days (labeled “days”) over which that
particular drawdown occurred.
Examination of the p-values indicates that both the EQ and SPD strate-
gies experience pure drawdowns that never occur in the simulations. Thus,
we can confidently reject the i.i.d. bootstrap even with consideration of the
Bonferroni bound. This is not true for the other three strategies where there
is insufficient evidence to formally reject the simulation models. These
results together suggest that controlling for serial dependence in volatility
greatly improves the accuracy of an i.i.d. approximation for studying the
extreme downside risks. Nevertheless, the decrease in the p-values for
smaller but still sizeable drawdowns suggests that we need a richer model
to capture the serial dependence in the data to fully match the frequencies
of less extreme but still severe downside events.
For the EQ strategy, the worst pure drawdown is 5.2% with a p-value
of .014, and it was experienced over 6 trading days. For less severe pure
drawdowns, we see that the bootstrap simulations also fail to match the
frequencies at these thresholds. For example, there are 10 pure drawdowns
greater than or equal in magnitude to 3.1% which never occurs in the
simulations. These pure drawdowns occurred between 3 and 11 business
days.
Similar observations can be made for the SPD strategy. Observing a
10th-largest pure drawdown of 4.4% never occurs in the simulations. In
results available in the online appendix, we observe that the durations
of the pure drawdowns, that is, the number of days with consecutive
negative returns, are well within the .05 bounds implied by simulations.
These results suggest that the low p-values of the empirical distributions
56 Kent Daniel et al

of the magnitudes of pure drawdowns stem mainly from the fact that the
consecutive negative returns tend to have larger variances than the typical
returns.31
For the risk-rebalanced strategies, EQ-RR and SPD-RR, we find that
the worst five pure drawdowns lie well within the .05 bounds, while less
extreme pure drawdowns happen more frequently than is implied by the
bootstrap’s .05 bound. For example, the fifth worst pure drawdown of
the SPD-RR strategy is 4.2%, and we observe five pure drawdowns of this
magnitude or larger in 22.1% of the bootstrap simulations. For the EQ-D$
strategy, the most severe pure drawdown was 5.7%, which occurred over
4 days. With a p-value of .23 this would not be considered a particularly
anomalous event. However, the 10-th worst pure drawdown is 3.9%,
which took 10 trading days. The likelihood of 10 pure drawdowns of this
magnitude or worse is only 3.2%, based on our simulations.
To sum up, studying these five carry trade strategies at the daily fre-
quency conveys rich information regarding downside risks. Although the
minimum daily returns are of similar size to the minimum monthly returns,
they do not occur in the same months. Maximum drawdowns occur over
substantial periods of time, often in highly volatile environments, sug-
gesting that extreme negative returns do not happen suddenly and could
possibly be avoided by traders who can re-balance daily. Drawdowns are
much larger than the daily losses, and simulations using an independent
bootstrap distribution fails to match the empirical frequencies of downside
events in most cases. Bootstrapping with a volatility forecasting model
helps to match the frequencies of the most extreme tail events in the data,
but it fails to match the frequencies of less extreme but still severe tail
events.

9 Conclusions

This paper provides some perspectives on the risks of currency carry trades
that differ from the conventional wisdom in the literature. First, it is
generally argued that exposure to the three Fama and French (1993) equity
market risk factors cannot explain the returns to the carry trade. We find
that these equity market risks do significantly explain the returns to an
31
Similarly, in unreported results, we find larger values of pure run-ups than is implied
by the simulations.
The Carry Trade: Risks and Drawdowns 57

equally weighted carry trade that has no direct exposure to the dollar. Our
second finding is also at variance with the literature. We find that our carry
trade strategies with alternative weighting schemes are not fully priced by
the HMLFX risk factor proposed by Lustig et al. (2011), which is basically a
carry trade return across a broader set of currencies. Third, we argue that
the time varying dollar exposure of the carry trade is at the core of carry
trade puzzle. A dynamic dollar strategy earns a significant abnormal return
in the presence of equity market risks, bond market risks, FX risks, and
a volatility risk factor. The dynamic dollar strategy also has insignificant
skewness, indicating that crash risk cannot explain its abnormal return. Our
fourth finding that is inconsistent with the literature is that the exposures
of our carry trades to downside market risk are not statistically significantly
different from their unconditional exposures. Thus, the downside risk
explanation of Dobrynskaya (2014) and Lettau et al. (2014) does not
explain the average returns to our strategies. We find that the downside
risk explanation of Jurek (2014) explains the non-dollar carry trade, but it
also fails to explain our dynamic dollar strategy.
We also show that both spread-weighting and risk-rebalancing the
currency positions improve the Sharpe ratios of the carry trades. It is
surprising that the returns to these strategies continue to earn significant
abnormal returns in the presence of the HMLFX risk factor proposed by
Lustig et al. (2011), which is basically a carry trade risk factor.
The choice of benchmark currency also matters. We show that equally
weighted carry trades can have a Sharpe ratio as low as 0.26 when the JPY
is chosen as the benchmark currency and as high as 0.78 when the USD
is chosen as the benchmark currency. Changing the base currency of the
carry trade dynamically changes the currency exposures which explains
the difference between these carry trade strategies.
Our conclusions about the profitability of the dynamic dollar strategy
differ from those of Lustig et al. (2014) who also investigate a ‘dollar carry’
strategy, but with a larger set of currencies. Empirically, their dollar carry
returns, like ours, have only a small correlation with the US equity market
return. Lustig et al. (2014) develop a reduced-form, multi-country affine
model, which matches many of the moments of the data, including an
unconditional correlation between dollar carry returns and world equity
market returns of .10, close to the .14 in the data. However, we conjecture
that their model would imply significant correlations between dollar carry
returns and both U.S. equity market and U.S. bond market returns, because,
58 Kent Daniel et al

in the model, these returns and dollar-denominated exchange rates are


driven by a common set of shocks. These implications are inconsistent with
our empirical findings. Thus, at this point, we think that explaining the
return to the dynamic dollar strategy in this paper is an open question.
We also initiate a discussion of the attributes of the distributions of
the drawdowns of different strategies using daily data, but rebalancing
the portfolios at a monthly interval. We do so in an intuitive way using
simulations, as the statistical properties of drawdowns are less developed
than other measures of risk such as standard deviation and skewness.
In most cases, the largest drawdowns of our carry trade strategies lie
outside of the 95% confidence intervals generated by simulating from
an i.i.d. bootstrap. We conclude that adding conditional autocorrelation,
especially in down states, is necessary to fully characterize the distributions
of drawdowns and the negative skewness that characterizes the monthly
data.
We began the paper by noting the parallels between the returns to the
carry trade and the rejections of the unbiasedness hypothesis. As with
any study of market efficiency, there are four possible explanations. We
do find that the profitability of the basic carry trade has decreased over
time, which suggests the possibility that market inefficiency and learning
explain the relatively larger early period returns that are not associated
with exposures to risks. But, we also find significant risk exposures which
suggests a role for risk aversion. The risks may also change over time, in
which case learning becomes a possible explanation, but this requires a
deviation from the basic rational expectations econometric paradigm. The
performance of the hedged carry trade suggests that a single unrealized
peso state is probably not the explanation of the data, although generalized
peso problems in which the ex post distribution of returns differs from the
ex ante distribution that rational investors perceived certainly cannot be
ruled out.
The Carry Trade: Risks and Drawdowns 59

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