improved Sharpe ratios of 0.69 for EW; 0.70 for RW; and 0.73 for T3, which should be compared with returns of 5.43% and a Sharpe ratio of 0.50 from table 6.
We do not expect hedge funds will rush to replicate these investment strategies. However, these results conclusively suggest that volatility is indeed a very important determinant of carry trade profits and therefore it is to be expected that a central bank's desire to keep exchange rate volatility low is likely to inadvertently modify incentives for carry trade investors.
Central banks in export-oriented economies with de jure floating exchange rates face continuous fluctuations of their currency in a market of astonishing size and where transactions happen at warp speed. Management of the exchange in a manner consistent with broad domestic macro-economic objectives, an inherently difficult task, is further complicated by the gyrations in foreign exchange markets induced by carry traders. While a stable exchange rate may be desirable for exporters, that same stability may generate unwanted carry trade activity and compound risks of currency collapses. This paper investigated carry trade incentives from the perspective of individual investors as a way to examine empirically what role does exchange rate volatility play in such decisions.
The critical component in determining carry trade profits is a good prediction of exchange rates. At least since Meese and Rogoff (1983) the profession has been well aware of the futility of such an enterprise. However, recent work by Jordà and Taylor (2009) and Brunnermeier et al. (2009) suggests that measurably profitable carry trade strategies can be devised when the fundamental equilibrium exchange rate and foreign exchange volatility are taken into account. Our paper corroborates some of these findings but more importantly, elucidates the specific contribution of each factor.
While an exploratory analysis about the drivers of the carry trade suggests that foreign exchange volatility plays a rather minor role relative to the fundamental equilibrium exchange rate (thus confirming Jordà and Taylor's 2009 findings) we find