Abstract

We evaluate the effectiveness of economic fundamentals in enhancing profit of carry trades. We simulate carry trades in Japanese yen and Swiss franc against six target currencies based on forecasts of exchange rate models of economic fundamentals. The performance results are compared against those of the benchmark random walk and AR (1) models. We find that carry trades perform better in risk-adjusted returns and produce less downside risk in the exchange rate models of economic fundamentals. Particularly, the best improvement in profit to carry trades comes when the economic fundamentals are used in a factor-augmented regression framework where the factor is time-varying and derived from the fundamentals. The result is robust for different time periods and after controlling for transaction costs.

Key words: Exchange rate models, Japanese yen and Swiss franc, carry trade, currency risk premium.