The Profitability of Currency Carry Trades in Developed Markets

Abstract

Currency carry trades are potentially market-moving investment strategies that aim to exploit interest rate differentials across economies. The strategy contradicts the economic theory of uncovered interest rate parity, which posits that higher interest rates should be neutralized by currency depreciation, leading to no systematic profits on average. Nevertheless, the profitability of the carry trade strategy is supported by academic evidence and is often attributed to multiple risk factors, including crash risk. To assess the existence of diversification benefits, this thesis first analyzes the empirical profitability of the currency carry trade and second investigates whether exposure to currency momentum and currency value effects enhances the risk-return characteristics of the standalone carry trade. Using an extensive dataset spanning from January 1976 to December 2024, we analyze the profitability of dollar-neutral G10 currency strategies, including the carry trade, momentum, and value strategies, as well as a combined strategy. We find empirical evidence for the existence of diversification benefits. A combination of the carry trade with currency momentum and currency value strategies outperforms the standalone carry trade on different performance metrics due to weak correlations of returns of the individual strategies. The combined strategy exhibits a Sharpe ratio of up to 0.67 compared to 0.50 for the standalone carry trade and substantially mitigates the exposure to crash risk. However, we find that the profitability of currency momentum and currency value strategies decreased over time. For practitioners, this implies that more sophisticated methodologies might be required to fully capture diversification benefits and that alternative combinations of currency strategies might have to be considered.