The performance of NDF carry trades

•We compare non-deliverable forward (NDF) and deliverable forward (DF) carry trades.•NDF carry trades offer higher Sharpe ratios compared to DF carry trades.•Covered interest differential reflects convertibility risk for NDF carry trades.•DF and NDF carry trades share common risk factors.•Global convertibility risk has a limited effect on carry trades.

This paper investigates the performance of carry trade strategies for currencies with non-deliverable forward (NDF) contracts. We find that carry trades for currencies with NDF contracts are associated with higher Sharpe ratios compared to carry trades for currencies with deliverable forward (DF) contracts. We also find that, during the recent financial crisis, DF carry trades incur heavy losses while NDF carry trades realize insignificant losses. DF carry trade payoffs are shaped by credit risk, global foreign exchange (FX) volatility and crash risk. In contrast, NDF carry trade payoffs are driven by global FX volatility and crash risk, liquidity risk, and currency convertibility risk measured by deviations from covered interest parity in offshore markets while global convertibility risk has a limited effect on carry trades.