The Time-Varying Systematic Risk of Carry Trade Strategies

To capture time-variation in the risk exposure of exchange rates, this paper suggests a factor model with stock and bond markets as the explanatory factors - but where the betas are allowed to depend on the exchange rate volatility. Empirical results on daily data from 1995 to 2008 show that a typical carry trade strategy based on 10 currencies from major industrialized countries has much higher exposure to the stock market and also more mean reversion in volatile periods. The findings are robust to various extensions, including adding more currencies and other regime variables.