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Carry trade returns and foreign exchange rate risk
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This paper analyses whether foreign exchange risk measures and its components have the ability to predict the return to the carry trade strategy. We employ a dynamic portfolio composed of 20 currencies. We first show that carry trade returns are related to the total variance of our portfolio of currencies. We then decompose the total variance of this portfolio in a component representing the average variance of this portfolio and another representing its average correlation. Since average correlation is not significantly related to carry trade returns, the predictive power of market variance is primarily attributable to average variance.
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Carry trade Average variance average correlation quantile regression