NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

The Carry Trade: Risks and Drawdowns

Kent Daniel, Robert J. Hodrick, Zhongjin Lu

NBER Working Paper No. 20433
Issued in August 2014
NBER Program(s):Asset Pricing, International Finance and Macroeconomics

We examine carry trade returns formed from the G10 currencies. Performance attributes depend on the base currency. Dynamically spread-weighting and risk-rebalancing positions improves performance. Equity, bond, FX, volatility, and downside equity risks cannot explain profitability. Dollar-neutral carry trades exhibit insignificant abnormal returns, while the dollar exposure part of the carry trade earns significant abnormal returns with little skewness. Downside equity market betas of our carry trades are not significantly different from unconditional betas. Hedging with options reduces but does not eliminate abnormal returns. Distributions of drawdowns and maximum losses from daily data indicate the importance of time-varying autocorrelation in determining the negative skewness of longer horizon returns.

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Document Object Identifier (DOI): 10.3386/w20433

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