Essays on currency carry trades

Abstract

This thesis investigates pricing models of currency carry trades. The main contribution of Chapter 2 is the use of an empirical method to summarise risk information and construct factor models. Carry trades partially share same risk characteristics with other asset markets, but some carry trade specific risk factors are also proposed. Therefore, a method to summarise overlapping information is proposed, and the type of information that is dominant in the risk factors is investigated. The important contribution of Chapter 3 is the provision of evidence of a a relationship between commodity prices and carry trade returns. Commodity prices co-move due to consumer income shocks whereas each commodity group has heterogeneity. The adopted approach takes into account these commonalities and heterogeneity. Furthermore, the overlap between commodity related information and financial market information is tested. Chapter 4 contributes with estimates of conditional factor models for carry trades. These models assume that alphas and betas are conditioned on economic states, and are time-varying. The analysis estimates alphas and betas by a nonparametric method and that allows smooth change in these parameters. Finally, the most important contribution in Chapter 5 is the investigation and provision of evidence of time variation in risk prices. Expected returns are decomposed into betas and risk prices. If expected returns change over time, then betas and/or risk prices vary over time. Recently developed dynamic factor models are adopted and used to investigate the impact of time-varying risk prices on pricing errors.