Carry Trades and Global Foreign Exchange Volatility






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    • Menkhoff and Schmeling are with Leibniz Universität Hannover, Sarno is with Cass Business School, City University London, and the Centre for Economic Policy Research (CEPR), and Schrimpf is with the Bank for International Settlements. The authors would like to thank Campbell Harvey (the Editor), an anonymous Associate Editor, two anonymous referees, Alessandro Beber, Nicole Branger, Francis Breedon, Craig Burnside, Joe Chen, Magnus Dahlquist, Marcel Fratzscher, Mathias Hoffmann, Søren Hvidkjær, Ravi Jagannathan, Ralph Koijen, Hanno Lustig, Pascal Maenhout, Ian Marsh, Tarun Ramadorai, Jesper Rangvid, Nick Roussanov, Carsten Sørensen, and Adrien Verdelhan, as well as participants at the Fifth Amsterdam Asset Pricing Retreat (2009), the Institute of Finance Workshop on International Asset Pricing in Leicester (2010), the European Finance Association 2009 Meetings in Bergen, and the German Economic Association Annual Conference 2009, and seminar participants at the Bank for International Settlements, Bank of England, Deutsche Bundesbank, European Central Bank, New York Federal Reserve Bank, and several universities for helpful comments and suggestions. Sarno acknowledges financial support from the Economic and Social Research Council (No. RES-062-23-2340), Schmeling gratefully acknowledges financial support by the German Research Foundation (DFG), and Schrimpf acknowledges support from ZEW, Mannheim, and from CREATES, funded by the Danish National Research Foundation. Any views expressed in this article are those of the authors and do not necessarily reflect those of the Bank for International Settlements.


We investigate the relation between global foreign exchange (FX) volatility risk and the cross section of excess returns arising from popular strategies that borrow in low interest rate currencies and invest in high interest rate currencies, so-called “carry trades.” We find that high interest rate currencies are negatively related to innovations in global FX volatility, and thus deliver low returns in times of unexpected high volatility, when low interest rate currencies provide a hedge by yielding positive returns. Furthermore, we show that volatility risk dominates liquidity risk and our volatility risk proxy also performs well for pricing returns of other portfolios.