The carry trade and fundamentals: Nothing to fear but FEER itself

Risky arbitraging based on interest rate differentials between two countries is typically referred to as a carry trade. Up until the recent global financial crisis, these trades generated years of persistent positive returns, which were hard to reconcile with standard pricing kernels. In 2008 these trades blew up, which seemed to weaken the case for a puzzle relating to predictable currency returns. But the rise and fall of this puzzle in the academic literature has only been concerned with naïve carry trades based on yield signals alone. We show, however, that some simple and more realistic fundamentals-augmented trading strategies would have generated strong and sustained positive profits that endured through the turmoil.

► We examine profits in- and out-of-sample from Naïve carry trades and other currency strategies. ► We look at periods up to and including the recent financial crisis. ► Tests (including a new correct classification frontier) assess accuracy and profitability. ► An augmented trading strategy with value and momentum contains valuable predictive information. ► It outperforms a Naïve carry trade, with higher returns, lower volatility, and small skew.