Journal of Applied Finance & Banking

Currency Regimes, Volatility Risks, and Carry Trades: The Option Value of Government Currency Intervention in Emerging Markets

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  • Abstract

     

    This study investigates the relationship between cross-sectional carry trade returns and global foreign exchange volatility risk. During periods of high volatility innovations, the average carry trade returns on emerging markets are higher than that of all countries or developed economies. Furthermore, the average returns on managed-float and fixed-rate carry trades are significantly higher than that of free-float carry trade. Government currency intervention in emerging markets can explain these differences. There is an option value in government currency intervention, which can be calculated using an American currency option model with stochastic strikes. This result has policy implications.


    JEL classification numbers: F31, G12, G18

    Keywords: Carry Trade, Emerging Markets, Currency Regime, Currency Intervention, Currency Option.