A Study On The Abnormal Return Of Carry Trade With Market Timing Based On Exchange Rate Volatility

This paper has proposed a carry trade strategy with market timing based on exchange rate volatility and has studied the strategy from three perspectives.First, an empirical analysis has been conducted concerning the effectiveness of the market timing strategy in return improvement and risk(especially tail risk) reduction. We have studied this question with descriptive statistics and asset pricing models. A sub-period analysis has also been conducted. Results show that the strategy has positive abnormal return from 2002 to 2014. Sub-period studies show that(1) from 2002 to 2014, the market timing strategy had impressive abnormal returns,(ii) 2002 to 2007, both the market timing and the non-timing strategies had positive abnormal returns; however, from 2007 to 2014, the non-timing strategy had negative abnormal returns while the timing strategy kept the positive abnormal returns(iii) market timing can smooth the returns of the non-timing carry trading strategy, moderate its tail risk, and immunize it against the negative influence of currency crises.Second, based on an investigation of many typical carry trade tail events, this paper has put the tail risks into four categories according to the source of risk. The four categories are policy risk, political risk, crisis risk, and gaming risk. An example of policy risk is the rapid appreciation of Swiss Franc in 2015, political risk is exemplified by the depreciation of Russian Peso in late 2014, crisis risk is illustrated with the yen appreciation in 2008, and the 1997 Thailand Bhat depreciation well explains the “gaming risk”. Since different tail risk episodes have drastically different economic backgrounds, we have adopted the case-by-case approach in analyzing the causes of tail risk events.Finally, we have studied why marketing timing based on exchange rate volatility can moderate the tail risk of carry trade strategy and the limitations of this market timing method. Results show that market timing typically requires investors to exit the carry trade strategy exactly when the carry trade yields the greatest interest spread, however interest spread widening typically precedes tail risk events; so at the sacrifice of small interest spread income, investors can avoid the large losses associated with the coming tail risk events. In real world applications, market timing based on exchange rate volatility has limitations, such as requiring investors exit carry trade when no tail risk events occur(type I error), and providing no warning before tail risk events actually happen(type II error).