that a more sophisticated approach (based on nonlinear specifications) rescues the relevance of volatility in determining future carry trade profitability. The first analysis relies on a novel panel local projection approach whereas the second is predicated on an out-of-sample predictive ability evaluation exercise based on investment loss functions rather than the more traditional statistical loss functions.
Nonlinearity in volatility turns out to be a very important factor in our analysis. We find that within a band of “tranquility” (defined by the level of foreign exchange volatility), exchange rates behave like a random walk although persistent carry trade profits can still be had owing to the limited variation in the currency. Outside of this band, reversion of exchange rates to their long-run fundamental equilibrium levels can cause dramatic carry trade wipe-outs that to some extent can be moderated by trading in the direction of purchasing power parity. Thus a piece of the puzzle is put together but surely the question of how central banks in small open economies oriented towards exporting should conduct optimal monetary policy deserves further research that accounts for the financial factors that we have highlighted in this paper.