Foreign Exchange Predictability during the Financial Crisis: Implications for Carry Trade Profitability

Stanislav Anatolyev, Nikolay Gospodinov, Ibrahim Jamali, and Xiaochun Liu

Working Paper 2015-6
August 2015

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In this paper, we study the effectiveness of carry trade strategies during and after the financial crisis using a flexible approach to modeling currency returns. We decompose the currency returns into multiplicative sign and absolute return components, which exhibit much greater predictability than raw returns. We allow the two components to respond to currency-specific risk factors and use the joint conditional distribution of these components to obtain forecasts of future carry trade returns. Our results suggest that the decomposition model produces higher forecast and directional accuracy than any of the competing models. We show that the forecasting gains translate into economically and statistically significant (risk-adjusted) profitability when trading individual currencies or forming currency portfolios based on the predicted returns from the decomposition model.

JEL classification: F31, F37, C32, C53, G15

Key words: exchange rate forecasting, carry trade, positions of traders, return decomposition, copula, joint predictive distribution

The views expressed here are the authors' and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors' responsibility.
Please address questions regarding content to Stanislav Anatolyev, New Economic School, 100A Novaya Street, Skolkovo, Moscow, 143026, Russia,; Nikolay Gospodinov (corresponding author), Research Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street NE, Atlanta, GA 30309-4470, 404-498-7892,; Ibrahim Jamali, American University of Beirut, Olayan School of Business 449, P.O. Box 11-0236, Riad El-Solh, Beirut, Lebanon 1107 2020,; or Xiaochun Liu, University of Central Arkansas, University of Central Arkansas, EFIRM Department, 201 Donaghey Ave, COB 211, Conway, AR 72035,
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