Carry Trade: Seeking Alpha, Risk-Based Explanation, and Relationship with Risky Assets

Unconditional interest rate parity states that interest rate differential between two currencies should be compensated by the change of the exchange rate between these two currencies (a currency which is corresponding to a higher interest rate should depreciate). Strategy of borrowing low yielding currency and lending high yielding currency should not yield any profit in the form of interest rate differential - carry. However, there is abundant empirical proof that this indeed does happen. UIP does not hold and, on the contrary, the exchange rate moves in an opposing direction, i.e. high yielding currencies oftimes appreciate in value. Many academic researches are devoted to figuring out this anomaly. The most common approach is based on assumption that abnormal returns from carry trade are a mere compensation for its risk. Academics devise various factors of risk which could potentially explain this deviation. Our work assumes the same approach, trying to explain cross-section variation of carry trade returns, among other things with behavioural risk factors. Our results show that factors proxying investors sentiment can indeed succeed at this task.