Home bias in currency carry trade

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School of Business | Master's thesis
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This thesis documents home bias in currency carry trade: i.e. carry trade activity from the main funding countries is biased towards investment countries that are located in the same region and thus more familiar to investors. My research provides new insight to the forward premium puzzle and arising currency carry trade excess returns stressing the importance of Switzerland, Japan and U.S. as the main funding countries in their own region during the sample period from January 1999 to January 2014. Utilizing spot and forward exchange rates of 28 currencies from EMEA, Asia Pacific and Americas, I form carry portfolios by sorting sample currencies based on their forward discount and examine the risk-return relationship between the main funding countries' funding liquidity measures and carry trade returns in these three regions. Furthermore, I test whether the tightening funding conditions in the main funding country are associated with currency crashes in the major investment countries located in the same region. The results indicate that the main funding countries' key volatility measures and liquidity spreads have in general the highest explanatory power for carry trade returns in their own regions. While the liquidity spreads produce less significant values relating to carry trade returns, they prove to be more relevant measures when explaining the currency crashes in the major investment countries. I show that the contemporaneous change in the Swiss and U.S. volatility measures can alone explain around 20 percent of the regional currency carry trade returns and crashes in EMEA and Americas, respectively, leaving other main funding countries' volatility measures redundant. In Asia Pacific, the changes in the key volatility measure have also delayed effect to carry trade returns due to slow collective action of numerous Japanese retail investors. Japanese and U.S. funding liquidity measures explain together one third of the carry trade excess returns and over 40 percent of the currency crashes in major investment countries in Asia Pacific region.
carry trade, home bias, regionality, forward premium puzzle, funding liquidity, implied volatility, risk aversion, TED spread, currency crash