“The Carry Trade: Risks and Drawdowns” by Robert J. Hodrick
Robert J. Hodrick
University of Georgia
We examine carry trade returns of G10 currencies. Performance depend strongly on the base currency. Dollar-neutral carry trades exhibit insignificant abnormal returns, while the dollar-exposure component of the carry trade earns significant abnormal returns with little skewness. Spread-weighting and risk-rebalancing of positions improves performance. Equity, bond, FX, volatility, and downside equity risks cannot explain profitability. Downside equity betas of our carry trades are not significantly different from unconditional betas. Hedging with options reduces but does not eliminate abnormal returns. Distributions of drawdowns and maximum losses from daily data indicate a role for time-varying autocorrelation in determining negative skewness at longer horizons.