Essays on currency carry trade in Africa’s emerging and frontier markets
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Date
2018
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University of Zululand
Abstract
The currency carry trade, an investment strategy where investors borrow funds from low-interest currency countries and invest the funds in financial assets domiciled in high-interest currency countries, has become very popular in the academic literature over the last two decades. The strategy exploits the failure of the uncovered interest rate parity (UIP) hypothesis which states that the interest rate differential between two countries is exactly offset by the depreciation of high interest rate currency over the investment time horizon. Thus this investment strategy is expected to yield zero returns if the uncovered interest rate parity condition holds. Its failure is well documented in literature, though these studies mostly concentrate on currencies of the developed world. This study implements the trade by targeting ten currencies of Africa‘s emerging and frontier markets, and fund the trade with four developed market currencies. The researcher first evaluates the profitability of the trade across all the forty currency pairs from 1998 to 2015. This is then followed by a rigorous analysis of returns using advanced risk-adjusted performance measures to test their viability as an alternative asset class or prudent investment. The study further examines a value-at-risk (VaR) analysis of the currency carry trade returns using generalised autoregressive conditional heteroskedasticity (GARCH) models. Finally, the study investigates the relationship or the information transmission mechanism between returns of the African currency carry trade and the returns of its respective Stock Markets. Different methodologies were employed to achieve the various objectives of this study. Notable among them are the Huber‘s robust regression, advanced portfolio performance evaluation measures, univariate generalised autoregressive conditional heteroskedasticity (GARCH) with value-at-risk and expected shortfall estimations, vector autoregressive Granger causality, panel vector autoregression (xtvar) and multivariate dynamic conditional correlation GARCH analysis. The study concludes that only a handful of the currency pairs studied were statistically profitable during and after the financial crisis of 2007. Naïve estimation of carry trade however produced some modest profits for a good number of the currency pairs. The study also concludes that some of the currency pair studied exhibit features of a viable investment and may be classified as an asset class. Furthermore, the researcher shows that the most appropriate approach to estimating the risk or value-at-risk of African currency carry trade returns is through the GARCH (1, 1) with skewed t distribution of the innovation. Finally, the implications of the African currency carry trade for the stock markets in Africa were found to be mixed. Thus African currency carry trade returns of twenty two currency pairs were found to significantly Granger cause the stock markets of the target currency countries, whilst evidence of causality could not be established for six currency pairs. A large number of currency pairs show one-way causality from the currency carry trade to the stock markets, with minimal amount of volatility spillover sparsely distributed across the selected African countries. For all the currency pairs together and the stock markets of Africa together, the study found that the stock markets respond greatly to shocks in carry trade whilst there appears to be very minimal response by carry trade to shocks in the stock markets.
Description
A thesis submitted to the Faculty of Commerce, Administration and Law in fulfillment of the requirements for the Degree of Doctor Of Philosophy (Phd) in the Department of Economics at the University Of Zululand, 2018
Keywords
currency carry trade --investment --low interest --currencies --high interest --emerging markets --Africa --trade