The carry trade is the investment strategy of going long in high-yield target currencies and short in low-yield funding currencies. Recently, this naive trade has seen very high returns for long periods, followed by large crash losses after large depreciations of the target currencies. Based on low Sharpe ratios and negative skew, these trades could appear unattractive, even when diversified across many currencies. But more sophisticated conditional trading strategies exhibit more favorable payoffs. We apply novel (within economics) binary-outcome classification tests to show that our directional trading forecasts are informative, and out-of-sample loss-function analysis to examine trading performance. The critical conditioning variable, we argue, is the fundamental equilibrium exchange rate (FEER). Expected returns are lower, all else equal, when the target currency is overvalued. Like traders, researchers should incorporate this information when evaluating trading strategies. When we do so, some questions are resolved: negative skewness is purged, and market volatility (VIX) is uncorrelated with returns; other puzzles remain: the more sophisticated strategy has a very high Sharpe ratio, suggesting market inefficiency.
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This paper was revised on December 5, 2011
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