To hedge or not to hedge: Carry trade dynamics in the emerging economies

Abstract

In this paper, we show that the carry strategy matters in the emerging markets in the sense that the dollar neutral carry strategy outperforms the dollar carry strategy. We also show that carry trade is not a profitable strategy, compared to the returns from U.S. stocks and/or U.S. dollar risk-free rate. Our findings indicate that risk factors explain the dollar carry strategies better than the dollar neutral strategy particularly in the post-crisis period. Because emerging markets are riskier than developed ones, investors are expected to hedge using FX options. However, we find that hedging carry trade is not a good idea in the emerging markets because crash risk that is priced in the options seems to evaporate carry profits.