Abstract:
This paper examines the predictive power of time-varying risk aversion over payoffs to the
carry trade strategy via the cross-quantilogram methodology. Our analysis yields significant evidence
of directional predictability from risk aversion to daily carry trade returns tracked by the Deutsche
Bank G10 Currency Future Harvest Total Return Index. The predictive power of risk aversion is
found to be stronger during periods of moderate to high risk aversion and largely concentrated on
extreme fluctuations in carry trade returns. While large crashes in carry trade returns are associated
with significant rises in investors’ risk aversion, we also found that booms in carry trade returns can
be predicted at high quantiles of risk aversion. The results highlight the predictive role of extreme
investor sentiment in currency markets and regime specific patterns in carry trade returns that can be
captured via quantile-based predictive models.