Carry Trade Strategies with Factor Augmented Macro Fundamentals : A Dynamic Markov-Switching Factor Model

This paper evaluates the performance of carry trade strategies with macro fundamentals in a Markov switching dynamic factor augmented regression framework and compares the performance statistics with the benchmark model of a random walk and momentum strategy. I make simulations with the Japanese Yen, Swiss Franc and US Dollar as funding currencies against six target currencies. Carry trade, a currency speculation strategy between the high-interest rate and low-interest rate currencies, generates high payoffs on average but has a possibility of crash risk. I argue that risk adjusted returns, mean returns and downside risk perform better when purchasing power parity model is used in a both regime switching and linear factor augmented regression framework for Franc trades and perform as good as benchmark model of momentum strategy for Dollar and Yen trades