TY  - JOUR
AU  - Jordà,Òscar
AU  - Taylor,Alan M.
TI  - The Carry Trade and Fundamentals: Nothing to Fear But FEER Itself
JF  - National Bureau of Economic Research Working Paper Series
VL  - No. 15518
PY  - 2009
Y2  - November 2009
UR  - http://www.nber.org/papers/w15518
L1  - http://www.nber.org/papers/w15518.pdf
N1  - Author contact info:
Òscar Jorda
Economic Research, MS 1130
Federal Reserve Bank of San Francisco
101 Market St.
San Francisco, CA 94105
E-Mail: oscar.jorda@sf.frb.org

Alan M. Taylor
Department of Economics
University of Virginia
Monroe Hall
Charlottesville, VA 22903
Fax: (434) 982-2904
E-Mail: alan.m.taylor@virginia.edu
AB  - 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.
ER  -