The Carry Factor And Global Risks

The carry factor is the tendency for higher-yielding assets to provide higher returns than lower-yielding assets — it is a cousin to the value factor, which is the tendency for relatively cheap assets to outperform relatively expensive ones. A simplified description of carry is the return an investor receives (net of financing) if prices remain the same. The classic application is in currencies — specifically, going long currencies of countries with the highest interest rates and short those with the lowest.

While currency carry has been both a well-known and a profitable strategy over several decades, the carry trade is a pervasive phenomenon, having been profitable across asset classes. For example, the 2015 study “Carry” by Ralph Koijen, Tobias Moskowitz, Lasse Pedersen and Evert Vrugt found the following:

While the concept of ‘carry’ has been applied almost exclusively to currencies, it’s a more general phenomenon that can be applied to any asset.

The chart below summarizes their core finding:

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index.

They defined carry as the expected return on an asset assuming its price does not change — that is, stock prices do not change, currency yields do not change, bond yields do not change, and spot commodity prices remain unchanged. Thus, for equities, the carry trade is defined by the dividend yield (the strategy is going long countries with high dividend yield and short countries with low dividend yield); for bonds, it is determined by the term structure of rates; and for commodities, it is determined by the roll return (the difference between spot rates and future rates).

More Evidence on the Carry Trade

The authors found that a carry trade that goes long high-carry assets and shorts low-carry assets earns significant returns in each asset class with an annualized Sharpe ratio of 0.7 on average. Further, a diversified portfolio of carry strategies across all asset classes earns a Sharpe ratio of 1.2. They also found that carry predicts future returns in every asset class with a positive coefficient, but the magnitude of the predictive coefficient differs across asset classes.

Mohammadreza Tavakoli Baghdadabad and Girijasankar Mallik contribute to the literature on the carry trade with their study, “Global Risk Co-Moments and Carry Trade Strategy,” which appears in the Spring 2018 issue of The Journal of Fixed Income. Their focus was on determining if the profitability of the carry trade could be explained by global risk factors.

They state:

A rational investor is theoretically concerned about variables influencing the investment opportunity set and tends to hedge against unexpected variations in market co-moments, stimulating risk-averse agents to demand a currency that hedges against these co-moments.

The demand for hedging properties leads to lower returns. Given this hypothesis, they investigated whether the sensitivity of excess returns to global co-moments in skewness (a measure of the asymmetry in a statistical distribution) and kurtosis (a measure of the tails of a frequency distribution when compared with a normal distribution) is able to rationalize currency portfolio returns in an asset-pricing framework. Specifically, they examined whether global co-skewness and co-kurtosis (the degree to which asset prices move together) are important drivers of risk premiums in explaining the cross-section of carry trade returns.

Their data sample included 52 currencies (22 developed and 30 emerging markets). Their equity sample excluded the smallest 5 percent of stocks by market capitalization. The currency portfolios were split into quintiles. The study covered the period from 1994 through 2016.

Baghdadabad and Mallik found that sorting currencies into the global co-moment betas leads to a large difference in currency portfolio returns. The result is a significant negative relation between high-interest-rate currencies and global co-skewness that delivers low returns during instances of unexpectedly high co-skewness when low-interest-rate currencies are used as a hedge by earning positive returns. Thus, the carry trade performs poorly in times of market depression. Therefore, the high returns to the carry trade can be rationalized from the standard asset-pricing perspective as compensation for time-varying risk. Specifically, they found a monotonically increasing pattern in average returns and Sharpe ratios when moving from portfolio 1 (lowest yielding) to portfolio 5 (highest yielding). The unconditional average excess returns from holding an equal-weighted currency portfolio was 2.9 percent (and 0.6 percent for a subsample of 14 developed countries).