The Empirical Study Of How Foreign Exchange Market Risk Effects The Excess Returns Of Carry Trades

With the great development of the global economy in the 1990s, as well as differences in central Banks monetary policy, the carry trades become the new darling of international investors. Currency carry trades are popular strategies that borrow in low interest rate currencies and invest in high interest rate currencies. In currency carry trades, excess returns from carry trades associated with two key factors:interest rate differential and exchange rate factors. Uncovered interest rate parity (UIP) theory shows that higher currency exchange rates have a trend of depreciation, and low interest rate of its exchange rates has a rising trend. According to the theory of uncovered interest rate parity (UIP), currency carry trades should not produce excess returns, but a large number of empirical studies have shown that the excess returns of carry trades does exist, the violate of uncovered interest rate parity (UIP) is the forward premium puzzle.The frame of the article includes six sections:the first section is about the introduction, the section is about the background, the research questions and the meaning. This section also includes the research matters, the innovations and shortcomings. The second section is theories. The theories have the definition of carry trades, forward premium puzzle and the copula, the copula is used to structure the independent variable. The third section is about literature, the literature is about carry trades and RMB exchange rate. The literature of carry trades includes external and domestic aspects. The forth section is data and models. The section includes the data, the constitution of carry trades and the risk of foreign exchange market. The risk of foreign exchange market consists of RX factor, the innovations of volatility factor and tail dependent factor. The RX factor is the average excess returns of foreign exchange market. The innovations of volatility factor indicate the risk of the foreign exchange market. The tail dependent factor indicates the significant joint depreciations or appreciations in the value of the high or the low interest rate currencies to speculative flows. The fifth section is the result. The section consists of the currency portfolios cross-sectional asset pricing and the time-series regressions. This section also includes the RMB exchange rate in carry trades. With the dot plot of RMB exchange rate, analyze the how often the RMB exchange rate is in carry trades, and the risk of carry trades to the RMB exchange rate. The sixth section is conclusion. The section summarizes the article and gives some relevant policy.The data includes 33 countries consisting of the G10 and the emerging market countries. The data for spot exchange rates and 1 month forward exchange rates versus the USD cover the sample period from January 1999 to December 2014. The exchange rate is in units of foreign currency per U.S. dollar. The validity of the covered interest rate parity relation has been demonstrated empirically in the currency market when one considers daily data. That is to say, the interest rate differentials are equal to the currency forward discount. The investing currency of the carry trades has high interest rates, and the funding currency of the carry trades has low interest rates. Under the CIP, according to currency forward discount, we form five such portfolios. Investing in the highest rate quintile (portfolio 5) and shorting the lowest rate quintile (portfolio 1) therefore results on a carry trade portfolio. Portfolio 1 contains the currencies with the lowest interest rate or smallest forward discount, and Portfolio 5 contains the currencies with the highest interest rate or largest forward discount. The excess returns on the carry trades buy a foreign currency in the forward market and then sell it in the spot market after one month. Portfolios are rebalanced at the end of every month. The excess return for portfolio is average excess returns of five portfolios.The article is from the foreign exchange market risk aspect to analyze the excess returns of carry trades. There are three risk factors in the article, namely RX risk factor, volatility risk factor and tail dependent risk factor. The RX factor is the average currency excess return of a U.S. investor who buys all foreign currencies available in the forward market. The volatility factor is the risk of the foreign exchange market. The tail dependence factor indicates when currency in the foreign exchange market crash caused risk contagion, the tail dependence factor is structure of funding and investment currency of carry trades.The empirical study of this paper uses linear stochastic discount model to analyze the excess returns of currency portfolio. We use GMM to estimate the model. Then we use OLS to do time series regression of currency portfolio.The main conclusion of this paper is that the foreign exchange market risk can affect the excess returns of carry trades. Firstly, the factor RX can only explain the common risk factor since it has the same effect on different currency portfolio. Second, the volatility risk factor has negative effect on the pricing of assets, it is to say that it can provide risk compensation. From the time series regression, volatility risk factors have different impact on different currency portfolios, it can explain the excess return in a positive way. Third, from the cross section data, the tail dependence factor has positive effect. However, in the time series regression, it influences the excess return in a negative way.The paper also analyze the RMB exchange rate behavior in the carry trades, it finds that RMB has been more and more active, which would bring more and more risks. When the volume of carry trades becomes large, the foreign exchange market risks influence the investors of carry trades and crash the exchange rate. Therefore, in the process of internationalization of RMB exchange rate, we need to prevent the foreign exchange market risk through the carry trades on the impact of the RMB exchange rate.According to the conclusion, the paper put forward some suggestions from the investors and government:First, from the perspective of investors, investors in the carry trades, not only to pay attention to difference in interest rates between currencies, but also pay attention to risks in foreign exchange markets. Second, authorities need to guard against foreign exchange market risks through carry trades impact on the RMB exchange rate. Namely, the government should strengthen the supervision of the exchange-rate market in order to prevent the potential risk. Then, the government should concentrate on the reform of market-oriented interest rates, improve the capital market as well. Last, the government should strengthen the supervision of the foreign trade enterprises, which is the most used way to participate in the carry trades.Significance of the article as follows:By analyzing the impact of risk on the foreign exchange market carry trades excess returns, from the perspective of the foreign exchange market risk, perfecting the theory research in the forward premium puzzle, as well as the carry trades investors provide certain theoretical support; Analysis of the RMB exchange rates in the carry trades, the foreign exchange market risk through the carry trade may be on the impact of the RMB exchange rate. In this case of the government to maintain the stability of the RMB exchange rates, the article puts forward relevant suggestions.