Exchange rate predictability, common factors, and applications in carry trade

摘要

In this paper, we investigate the predictive ability of foreign exchange rate models with macroeconomic fundamentals and common risk factors on the returns to the carry trade. We simulated trading strategies against target currencies of both developed and emerging market currencies using the Japanese Yen as the funding currency. These strategies are constructed by predicting exchange rates with macroeconomic fundamentals and common risk factors. The returns of carry trade strategies are compared against the benchmark models of Random Walk and AR (1) models. We argue that the trading strategy with the carry factor outperforms the benchmark models for emerging market currencies by all measures, and both the carry factor and carry factor augmented Taylor rule models outperform the benchmark models for developed countries' currencies in terms of mean returns and Sharpe ratios. The results are robust to different trading periods and transaction costs.