Do Currency Fundamentals Matter for Currency Speculators?

February 1, 2010

Disclaimer: This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate

Summary

The answer seems affirmative. We compare currency carry trades with an investment strategy based on currency fundamentals: taking a long (short) position in undervalued (overvalued) currencies. Carry trades have high risk-adjusted returns, but are subject to "crash risk." In contrast, the fundamental strategy has lower risk-adjusted returns, but is less prone to crash risk, because the realization of crash risk coincides with corrections towards fundamentals. In particular, the fundamental strategy outperformed carry trades during the recent global financial crisis. Building on these results, we present early warning indicators for potential turbulence in the currency market.

Subject: Currencies, Exchange rate adjustments, Exchange rates, Foreign exchange, Money, Purchasing power parity, Real effective exchange rates

Keywords: carry trade strategy, carry trades, commodity-currency portfolio, Currencies, currency carry trades, currency fundamentals, currency speculation, currency speculation strategy, Danish krone, Exchange rate adjustments, Exchange rates, Global, pound sterling, Purchasing power parity, Real effective exchange rates, Sharpe ratio, WP

Pages:
34
Volume:
2010
DOI:
---
Issue:
039
Series:
Working Paper No. 2010/039
Stock No:
WPIEA2010039
ISBN:
9781451962864
ISSN:
1018-5941

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