Stanislav Anatolyev, Nikolay Gospodinov, Ibrahim Jamali, and Xiaochun Liu
Working Paper 2015-6
In this paper, we study the effectiveness of carry trade strategies during and after the financial crisis using a flexible approach to modeling currency returns. We decompose the currency returns into multiplicative sign and absolute return components, which exhibit much greater predictability than raw returns. We allow the two components to respond to currency-specific risk factors and use the joint conditional distribution of these components to obtain forecasts of future carry trade returns. Our results suggest that the decomposition model produces higher forecast and directional accuracy than any of the competing models. We show that the forecasting gains translate into economically and statistically significant (risk-adjusted) profitability when trading individual currencies or forming currency portfolios based on the predicted returns from the decomposition model.
JEL classification: F31, F37, C32, C53, G15
Key words: exchange rate forecasting, carry trade, positions of traders, return decomposition, copula, joint predictive distribution