Abstract:
This paper examines the role of long-run and cyclical components of interest rate differentials in explaining the returns to currency carry strategies. We show that long-run differentials account for most of the profitability, while cyclical differentials play only a limited role. A simple strategy that goes long currencies above the median long-run differential and shorts those below delivers a statistically and economically significant annualized excess return of 2.48%. Relative to traditional carry, our strategy achieves a higher Sharpe ratio, lower turnover and a less negative skewness. We introduce a new tradable carry factor that explains the cross section of currency returns beyond the benchmark carry factor.