The Cost to Carry: Investor Uncertainty and the Currency Risk Premia

Abstract

This thesis explores a risk-based explanation of carry trade returns in currency markets. We propose a two-factor model that uses investor uncertainty proxied by News Implied Volatility innovations (NVIX) and the dollar factor to explain the profitability of the carry trade strategy. This model explains 86% of the variation in currency returns. The NVIX innovations factor commands a negative risk premium of 12.9% per annum. In addition, we use NVIX’s forecasting ability in carry trade returns to hedge the downside risk and improve the profitability of the carry trade strategy.