FX carry has been a go-to strategy for currency traders, but it is not without risks. For many, holding high yielding currencies and shorting a low yielding basket will generate steady positive returns until there is a shock to the system and markets switch to a return free-fall. The downside risk can be extreme when there is a crisis and leads to the analogy of picking up nickels before a steamroller.
Recent work has focused on measuring conditional skew in currency markets. See "Conditional Skewness in Currency Markets" by Alina Steshkova. She models the distribution of currencies as skew-t distributed and finds a strong negative relation between skew and interest differentials as well as real exchange rates. Currencies with high interest differentials or show high real exchange rates will exhibit negative skew. This result is applicable to both developed and emerging markets. Skew is time varying because the underlying factors associated with skew are time varying.
What makes this work especially interesting is that conditional skewness can forecasts currency risk premia and is priced within carry trade portfolios. The cross-sectional carry returns can be explained by skew as a dominant characteristic especially for high interest rates even after accounting for the dollar as the reserve safe currency and volatility.
The value from this information is significant if you want to trade currency carry. Beware of negative skew and if you think you are getting paid just for carry, you are wrong. This skew should be seen in currency options and if it is not priced in the market, there are opportunities to build portfolios that can either hedge carry risk or for options strategies that can create a slight return edge.
Even for the simple carry strategies, knowing that return is being generated from taking skew risk is valuable information. There is no free lunch, but there is a menu for what you will get at lunch.
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