VITALY ORLOV Essays on Currency Anomalies ACTA WASAENSIA 366 BUSINESS ADMINISTRATION 146 Reviewers Professor Johan Knif Hanken School of Economics, Department of Finance and Statistics PB 287 FI-65100 VAASA Finland Professor Paul Söderlind University of St. Gallen, Swiss Institute for Banking and Finance Rosenbergstrasse 52 CH-9000 St. Gallen, SWITZERLAND III Julkaisija Julkaisupäivämäärä Vaasan yliopisto Joulukuu 2016 Tekijä(t) Julkaisun tyyppi Vitaly Orlov Artikkeliväitöskirja Julkaisusarjan nimi, osan numero Acta Wasaensia, 366 Yhteystiedot ISBN Vaasan yliopisto Laskentatoimi ja rahoitus Vaasan yliopisto PL 700 FI-65101 VAASA 978-952-476-716-3 (painettu) 978-952-476-717-0 (verkkojulkaisu) ISSN 0355-2667 (Acta Wasaensia 366, painettu) 2323-9123 (Acta Wasaensia 366, verkkojulkaisu) 1235-7871 (Acta Wasaensia. Liiketaloustiede 146, painettu) 2323-9735 (Acta Wasaensia. Liiketaloustiede 146, verkkojulkaisu) Sivumäärä Kieli 147 englanti Julkaisun nimike Esseitä valuuttamarkkinoiden anomalioista Tiivistelmä Tämä väitöskirja tutkii valuuttamarkkinoiden anomalioita. Neljä toisiinsa tiiviisti liittyvää tutkimusta tarkastelee valuuttakurssien tunnusomaisia riskitekijöitä, niiden ominaisuuksia ja tarjoaa riskiin perustuvan selityksen valuuttamarkkinoiden korkoero- ja momentum-ilmiöille. Ensimmäisessä esseessä tutkitaan osakemarkkinoiden likviditeetin vaikutusta näiden ilmiöiden epänormaaleille tuotoille. Toisessa ja kolmannessa esseessä tutkitaan valuuttojen korkoeroilmiön riskiprofiileja ja tarjotaan riskiin pohjautuva selitys epänormaaleille tuotoille. Neljännessä esseessä tutkitaan korkoerostrategian hajautusmahdollisuuksia ja tarkastellaan valuuttojen yhteisriippuvuutta. Ensimmäisen esseen tutkimustulokset osoittavat, että osakemarkkinoiden likviditeetti selittää momentum-sijoitusstrategian tuottoja valuuttamarkkinoilla, mutta se ei selitä valuuttojen korkoeroon perustuvan sijoitusstrategian tuottoja. Toisen esseen tutkimustulokset osoittavat, että valuuttojen korkoeroilmiötä voidaan selittää valtioiden vakavaraisuuteen liittyvällä riskipreemiolla, joka vaihtelee yli ajan. Kolmannen esseen empiiriset tulokset osoittavat, että korkoeroon perustuvan sijoitusstrategian tuotot linkittyvät myös maiden poliittiseen riskiin, antaen samalla riskiin pohjautuvan selityksen. Neljännen esseen tutkimustulokset puolestaan osoittavat, että aalloke-korrelaatioita hyödyntävä sijoitusstrategia antaa huomattavia hajautushyötyjä ja löytää hyödynnettäviä malleja valuuttakurssien muutoksissa. Kollektiivisesti voidaan sanoa, että näiden neljän esseen tutkimustulokset tarjoavat uutta tietoa valuuttakurssianomalioiden ominaisuuksista ja niitä selittävistä riskitekijöistä. Asiasanat Korkoerostrategia, momentum-ilmiö valuuttamarkkinoilla, markkinalikviditeetti, vakavaraisuuden riskipreemio, poliittinen riski, hajauttaminen V Publisher Date of publication Vaasan yliopisto December 2016 Author(s) Type of publication Vitaly Orlov Doctoral thesis by publication Name and number of series Acta Wasaensia, 366 Contact information ISBN University of Vaasa Accounting and Finance University of Vaasa P.O. Box 700 FI-65101 Vaasa Finland 978-952-476-716-3 (print) 978-952-476-717-0 (online) ISSN 0355-2667 (Acta Wasaensia 366, print) 2323-9123 (Acta Wasaensia 366, online) 1235-7871 (Acta Wasaensia. Business Administration 146, print) 2323-9735 (Acta Wasaensia. Business Administration 146, online) Number of pages Language 147 English Title of publication Essays on Currency Anomalies Abstract This thesis investigates various aspects of currency market anomalies. Four interrelated essays examine risk characteristics, explore the attributes, and provide risk-based interpretation of the two currency anomalies, namely currency carry trade and currency momentum. The first essay examines the effect of equity market illiquidity on the excess returns of these anomalies. The second and third essays explore the risk profile of currency carry trades and offer risk- based interpretation of strategy’s payoffs. The fourth essay investigates carry trade diversification opportunities and linkages of major carry trade currencies. The findings of the first essay indicate that equity market illiquidity explains the evolution of currency momentum strategy payoffs, but not carry trade. The results of the second essay show that currency carry trades can be rationalized by the time-varying risk premia originating from the sovereign solvency risk. The third essay finds that carry trade profitability depends on a country’s political risk, supporting the risk-based view on forward bias. The fourth essay shows that strategies built on the basis of wavelet correlation have significant diversification benefits and finds exploitable patterns in exchange rate movements. Collectively, the findings of the four essays provide new evidence on the attributes of currency anomalies, supply a number of original results, and add to the international finance literature. Keywords Carry Trades, Currency Momentum, Market Illiquidity, Solvency Risk Premia, Political Risk, Carry Trade Diversification VII DEDICATION This work is dedicated to my Mom. IX ACKNOWLEDGMENTS Throughout my academic journey, I have grown tremendously in both a professional and personal way, and I owe it all to the amazing people I was fortunate enough to meet on the way. It is truly a special moment in my life and I feel thrilled to finally be able to express my deepest gratitude to people who provided support and opportunities throughout my doctoral studies. First of all, I would like to thank my supervisor Professor Janne Äijö, who recognized the potential in me, persuaded me to join the department, and guided me though the doctoral program. It feels that I could fill another book just mentioning the numerous ways in which Professor Äijö contributed to my success. He guided me through the first steps of academic career, coauthored my first paper, encouraged me in any possible way, not even mentioning that he was always there willing to help whenever I needed an advice. I can say that he truly became an academic father figure for me. Also, I wish to express my gratitude to the pre-examiners of this dissertation, Professor Johan Knif from the Hanken School of Economics and Professor Paul Söderlind from the University of St. Gallen. Their valuable comments improved the quality of this dissertation and provided good ideas for future research. Over these years, I have been fortunate to work among truly distinguished scholars, so valuable support and advice were always there. Special acknowledgment is owed to Professor Sami Vähämaa, who as head of the department at the time, offered me employment and initially recruited me as a research assistant for his project. Also, I thank Professor Vanja Piljak, Professor Klaus Grobys, and Antti Klemola for their friendship and support throughout the GSF coursework and doctoral studies in general. Last but certainly not least, I would like to thank my dearest friend and colleague Nebojsa Dimic, with whom I coauthored six papers during the last several years. Nebojsa was always there for me especially during the downturns and this stage of my life could never be achieved without his unconditional friendship. Indeed, the universe conspired in my favor and was blessed to have these wonderful people around me. During my studies, I was privileged to make two research visits to Columbia Business School in the USA and CUNEF in Spain. I wish to thank Professor Lars Lochstoer (CBS) and Professor Ana Isabel Fernández (CUNEF) for inviting me as a visiting scholar and giving me an opportunity to present my work. Also, I’m very grateful to Department of Accounting and Finance (and especially Prof. Timo Rothovius as the head of the department), the OP-Pohjola Group Research X Foundation and Marcus Wallenberg foundation for proving financial support for these research visits. Over the years, the essays of this dissertation have been presented at many conferences, workshops and seminars. Therefore, I wish to thank all of the seminar participants at Aalto School of Economics, Columbia Business School, University of Vaasa and CUNEF, and also discussants and participants in the PhD Nordic Finance Workshop (Bergen, 2016), the IFABS Conference (Barcelona, 2016) the 14th INFINITI Conference on International Finance (Dublin, 2016), the Graduate School of Finance Winter Workshop (Helsinki, 2015), the 2015 Midwest Finance Association Annual Meeting (Chicago, 2015), the 2015 Eastern Finance Association Annual Meeting (New Orleans, 2015), the NHH Empirical Asset Pricing workshop (Bergen, 2014), the 2014 Australian Finance and Banking Conference (Sydney, 2014), the Portuguese Finance Network Meeting (Vilamoura, 2014), the 21st SFM (Kaohsiung, 2013). In particular, I would like to thank Nikolai Roussanov, Michael Bowe, Kent Daniel, Lars Lochstoer, Doron Avramov, Peter Nyberg, Mikko Leppämäki, Matti Suominen, Chris Telmer, Alexey Semenov, Marku Kaustia, Ana Isabel Fernández, Maria T. Gonzalez-Perez, Daniel Buncic, Tai David Yi, Darya Yuferova, Sean Yoo, Janne Äijö, and Sami Vähämaa for providing valuable comments and suggestions. I gratefully acknowledge the financial support for my dissertation from the Graduate School of Vaasa and thank University of Vaasa for employing me during the years of my doctoral studies. I will always look back and cherish my experience here. Above all, my deepest gratitude is to my Mom. All those years that I lived far away I never felt far from home because she was always there rooting for me and loving me unconditionally. Perhaps, she has been even more concerned about my progress than I ever was. She has taught me many things that will live in my head and heart for a lifetime. She taught me how to love and have an open heart, taught me how to rise above circumstances and give my very best at everything I do, and that nothing is impossible. She is my blessing, my hero, and this work is dedicated to her. Vaasa, June 2016 Vitaly Orlov XI Contents DEDICATION ......................................................................................... VII ACKNOWLEDGMENTS ............................................................................. IX 1 INTRODUCTION ................................................................................. 1 2 CONTRIBUTION OF THE DISSERTATION .............................................. 3 3 THEORETICAL FUNDAMENTALS .......................................................... 6 3.1 Interest rate parity conditions and the forward premium puzzle ..................................................................................... 6 3.2 Currency anomalies ................................................................. 7 3.2.1 Currency carry trade and explanations of excess returns ...................................................................... 7 3.2.2 Currency momentum and market liquidity .............. 10 4 SUMMARY OF THE ESSAYS ............................................................... 13 4.1 Currency momentum, carry trade, and market illiquidity ........ 13 4.2 Solvency risk premia and the carry trades .............................. 15 4.3 The effect of political risk on currency carry trade ................. 17 4.4 Benefits of wavelet-based carry trade diversification .............. 18 REFERENCES .......................................................................................... 20 XIII This dissertation consists of an introductory chapter and the following four essays: Orlov, V. (2016). Currency momentum, carry trade, and market illiquidity. Journal of Banking and Finance, 67, 1-11.1 Orlov, V. (2016). Solvency risk premia and the carry trades. Proceedings of the 14th INFINITI Conference on International Finance. Dimic, N., V. Orlov, and V. Piljak (2016). The effect of political risk on currency carry trades. Finance Research Letters (forthcoming).2 Orlov, V. and Äijö, J. (2015). Benefits of wavelet-based carry trade diversification. Research in International Business and Finance, 34, 17-32.3 1 Printed with kind permission of Elsevier. 2 Printed with kind permission of Elsevier. 3 Printed with kind permission of Elsevier. 1 INTRODUCTION This doctoral dissertation investigates various aspects of foreign exchange market anomalies in four inter-related essays. The comprehension of exploitable disparities in macroeconomic conditions and positive average historical returns of currency anomalies has been the central topic of the international finance literature over the last three decades. The focus of this dissertation is on two anomalies: currency carry trade and currency momentum. The first essay examines both currency momentum and carry trade, the second and fourth essay investigate only the currency carry trade strategy, and the third essay separately explores individual currency carry trades. The global currency market is the biggest financial market, and has a trading volume twelve times greater than that of all the world’s stock markets (Triennial Central Bank Survey, 2010). Interestingly, only 10% of the volume is associated with the maintenance of international trade while the rest can be partly attributed to speculative activity. The scope and prominence of currency market arbitrage are due to persistent deviations from macroeconomic parity conditions, namely uncovered interest parity, and empirical rejection of the forward rate unbiasedness hypothesis; that is, the forward premium is an apparent biased predictor of a future spot exchange rate change, as manifested in Hansen and Hodrick (1980, 1983) and Fama (1984). These feasible discrepancies in macroeconomic parity conditions give rise to positive average historical currency excess returns and the forward premium puzzle. Seeking an explanation of the forward premium puzzle and currency excess returns is a current and prime topic in international finance. The purpose of this dissertation is to investigate risk characteristics, explore the attributes, and provide a risk-based interpretation of the two most prominent currency anomalies in the international finance literature, namely currency carry trade and currency momentum: the two currency anomalies rooted in the existence of the forward premium puzzle. Currency carry trade strategy is implemented by borrowing in a low interest rate currency and subsequently investing in a high interest rate currency. Currency momentum is a long-minus- short strategy based on lagged currency excess returns. The explanation of the profitability of these two anomalies is a topical and important research subject, as indicated by the many recent studies in the international finance literature (see, e.g., Lustig, Roussanov, and Verdelhan, 2011; Menkhoff, Sarno, Schmeling, and Schrimpf, 2012a; Lettau, Maggiori, and Weber, 2014; Daniel, Hodrick and Lu, 2016; Ready, Roussanov, and Ward, 2016 and others). This dissertation 2 Acta Wasaensia builds upon much of the recent evidence as well as classic contributions and, through its four essays, significantly expands the existing literature and reveals novel evidence on different aspects of the forward premium puzzle and the foreign exchange market anomalies. The remainder of the introductory chapter is organized as follows. Section 2 describes the contribution of each essay and also the dissertation as a whole. Section 3 provides a brief description of the theoretical background of the four essays of this dissertation and is followed by the summaries of essays provided in Section 4. Acta Wasaensia 3 2 CONTRIBUTION OF THE DISSERTATION The four essays that comprise this dissertation provide new evidence on the foreign exchange market anomalies and add to the current topics of the international finance literature. However, each of the essays approaches the topic from a slightly different perspective. The first essay explores how equity market conditions contribute to the observed returns of the currency momentum and carry trade strategies, while it does not aim to provide a complete explanation for the anomalies. In contrast, the second and the third essay approach the topic from the angle of risk-based interpretation and shed light on the possible origins of heterogeneities in the cross section of currency returns. The fourth essay deviates from the subjects of predecessors to investigate linkages among common carry trade currencies, while addressing the topic from a practical perspective. The common ground for all of the four essays is in the examination of various aspects of currency anomalies. This dissertation as a whole makes a number of contributions to the finance literature, while each of the four essays adds to various specific streams of the international finance and macroeconomic literature related to the return predictability of currency anomalies, cross-market segmentation of predictability, inter-market linkages, currency market liquidity, risk-based explanations of the forward premium puzzle, currency risk premia, international portfolio diversification, and the financial crisis. Accordingly, this dissertation through its interconnected constituent essays unites those contemporary international finance topics and sheds light on each of them. Collectively, the inferences from the four essays of this dissertation help advance understanding of the attributes of currency anomalies, identify a number of original results, and substantially add to the international finance literature. A more detailed description of the contribution of each essay is provided below. The first essay of this dissertation contributes to a number of strands of literature in several important ways. First, the essay extends the strand of literature on return predictability of currency anomalies, by exposing the predictive role of equity market illiquidity in explaining the inter-temporal variations in currency momentum returns. Further, the essay addresses the critique that the literature on predictability is segmented across markets. Despite its importance, there is little evidence available on the cross-market links between currency anomalies on the one hand and stock market conditions on the other. Hence, the first essay contributes toward filling this gap. Second, the findings of the essay provide 4 Acta Wasaensia additional support for the theoretical framework that links market liquidity and funding liquidity. Third, the essay contributes to the strand of literature on recent trends in market anomalies by providing evidence on the two most prominent currency market anomalies payoff realizations and their interaction with equity market conditions over the most recent decade. Finally, this study provides additional support to the prior literature that documents the linkage between equity and foreign exchange markets. The second essay makes several contributions to the international finance literature. First, the empirical findings of this essay lend additional support to the risk-based view of the forward premium puzzle, manifested in studies such as those of Hansen and Hodrick (1980), Fama (1984). This essay shows that the apparent slump in UIP can be interpreted as a compensation for risk. Second, this essay extends the findings of prior literature searching for an appropriate time-varying currency risk premium that rationalizes returns to the carry trade strategy. The essay identifies a new source of risk premia and shows that currency carry trades can be comprehended as a compensation for sovereign solvency risk. In addition, it introduces a new, solvency-based, risk factor and shows that its covariance with returns accounts for almost all of the variation in the cross-section of carry trade returns. Third, relying on fundamental measures of the financial competence of the economy, the second essay adds to the prior literature on a country’s creditworthiness as an explanation of currency carry trades, while addressing the critique of applying market measures to assess sovereign financial solvency. The third essay, in a similar way to the second paper, contributes to the strand of literature searching for an appropriate source of risk to explain the existence of the forward premium puzzle. The third essay takes a step along this path and contributes to the international finance literature by showing that carry trade returns are high/low in countries with high/low values of the composite political risk measure. The evidence in the third essay suggests that individual carry trades are heterogeneously exposed to political risk that, potentially, makes it more difficult for economic agents to predict future spot exchange rates of politically distressed countries, reinforcing the forward premium bias. In addition, the third essay adds to the literature on emerging market finance in showing that the political risk effect originates in emerging economies, while it is not evident in developed countries. The fourth and final essay makes several contributions to the relevant segments of international finance literature. First, the essay adds to the literature on international portfolio diversification and inter-market linkages in the foreign Acta Wasaensia 5 exchange market by extending the analysis of carry trade diversification opportunities and examining the temporal structure of correlations among the most common carry trade currencies. Second, the fourth essay employs a wavelet technique in assessing correlation structure in the currency market and thus enriches the growing literature on the linkages between currencies. In addition, the essay provides new evidence on the inter-market linkages around the dates of the global financial crisis. The third element of contribution of the essay is reflected in its investigation of carry trade excess returns on five different time scales. Therefore, the study aims to extend the existing literature that employs static correlation and a single investment horizon approach in portfolio construction. 6 Acta Wasaensia 3 THEORETICAL FUNDAMENTALS This section briefly presents the theoretical background and the analytical framework underpinning this dissertation and each of the four essays therein. First, Section 3.1 provides an overview of the evidence on macroeconomic parity conditions and the forward premium puzzle, which are common fundamentals for all four essays. Next, the following subsections set out the literature background of each constituent essay with the appropriate arrangements based on the corresponding foreign exchange market anomaly. 3.1 Interest rate parity conditions and the forward premium puzzle Over recent decades, the foreign exchange market efficiency debate has taken place in the framework of forward exchange rate predictive ability; that is, under an assumption of the currency market being efficient, a forward rate must reflect the market expectations of the level of the future spot exchange rate which will prevail at the time the forward contract matures: Et ((St+T) | Ωt) = Ft,T , (1) where rational expectations of the future spot exchange rate given the set of information Ω at time t equate to the forward rate Ft perceived by the market at time t as an accurate predictor of future spot rate (at time T). There are two macroeconomic conditions that theorize the forward-spot rate relationship, namely covered and uncovered interest parities. Covered interest parity postulates that the domestic interest rate is higher or lower relative to the foreign interest rate by an amount that is equal to the forward discount or premium. In practice, empirical tests document that the forward premium is indeed closely linked to the interest rate differential and no long-lived profitable arbitrage opportunities exist if transaction costs are accounted for, lending support to the covered interest parity condition (see, e.g., Frenkel and Levich 1975, 1977; Taylor 1987; Akram, Rime and Sarno, 2008; Baba and Packer, 2009). In contrast to covered interest parity, uncovered interest parity presumes no- arbitrage condition with no forward hedging against exposure to exchange rate risk. Thus, provided that uncovered interest parity holds, high interest rate currency depreciation offsets the interest rate differential (forward premium) and Acta Wasaensia 7 returns to currency speculation are zero. In practice this would mean that the slope coefficient of the Fama (1984) regression of exchange rate change on the prior interest rate differential is equal to unity: ST − St = α + β�Ft,T − St� + εT , (2) where ST − St is the spot exchange rate change, Ft,T − St is the log forward discount, that under covered interest parity is approximately equal to the cross- country interest rate differential at time t, and εT is a random disturbance term. According to the theoretical prediction of the uncovered interest parity condition, the slope coefficient in (2) is equal to one. However, empirical results of such a test of the unbiasedness hypothesis indicate that β is not only far from unity, but also on average far lower than zero (Fama, 1984; Froot and Thaler, 1990; Engel, 1995). This implies negative covariance between the risk premium and an expected depreciation. Hence, theoretical predictions of parity conditions are violated in the data, such that on average low interest rate currencies depreciate relative to the high interest rate currencies. The forward premium is consistently shown to be a biased predictor of a future spot exchange rate change over the last three decades (Lewis, 2011). These exploitable disparities in macroeconomic conditions stipulate positive average historical returns on currency speculations and the existence of a forward premium puzzle, that remains a primary and unresolved topic of international finance literature. 3.2 Currency anomalies 3.2.1 Currency carry trade and explanations of excess returns The carry trade strategy is executed by borrowing in currencies with low interest rates and investing in currencies with high interest rates. The exercise of the carry trade strategy is firmly related to the forecasting shortcomings of forward rates, which was previously referred to as the forward premium anomaly. Specifically, forward premia, contrary to the unbiasedness hypothesis, fall short in predicting future spot exchange rate appreciation. If forward rates were unbiased, the carry trade returns would be indistinguishable from zero. The explanation of positive historical carry trade payoffs has become a cornerstone of understanding the forward premium puzzle. Historically, foreign exchange market arbitrage is a long standing issue of international finance stretching back as far as the pre-gold standard study of Keynes (1923). Nevertheless, literature on 8 Acta Wasaensia the forward premium puzzle emerged in the early 1980’s and has often identified four major ways to interpret the existence of carry trade returns and the empirical rejection of the forward unbiasedness hypothesis. The first stream of literature strives to provide a risk-based explanation for the puzzle through defining carry trade returns as a compensation for an appropriate risk. Building on the classic contribution of Hansen and Hodrick (1980), Fama (1984) brings the discussion to the efficient markets framework and illustrates the apparent failure of UIP across various currencies and time periods, which manifests in negative estimates of the slope parameter of the so-called Fama- regression (2). Importantly, the residual component of that regression is interpreted as the time-varying currency risk premium that rationalizes returns to the carry trade strategy. Alternatively, the existence of that residual component is taken as evidence of market inefficiency, constituting the second interpretation. Pioneered by Bilson (1981), the interpretation shows that the nature of forward premium bias is broadly coherent with the behavioral finance perspectives found in Froot and Thaler (1990). Burnside, Han, Hirshleifer, and Wang (2011) argue that the forward premium puzzle can be explained by investor overconfidence causing an overreaction to macro information and discrepancies in forward and spot rate responses. The third class of explanations focuses on errors in market expectations due to the potential for “peso problems”, a term first introduced by Krasker (1980) to describe how uncertainty about a future shift in regimes results in biased measures of market expectations and, hence, a skewed distribution of forecast errors. In addition, Kaminsky (1993), Evans (1996), and Burnside, Eichenbaum, Kleshchelski, and Rebelo (2011) examine peso problems, measurement errors, and rare disasters, and infer that forward rates are biased. Furthermore, Lewis (2011) shows that potentially rare disasters may bias slope estimates of the Fama-regression. Building on evidence of peso problems, Lewis (1989) demonstrates that learning effects can account for as much as half of the magnitude of forward premium bias. In addition, several studies focus on the interpretation of the puzzle from the microstructure point of view, constituting the fourth class of explanations. Evans and Lyons (2002) adopting the microstructure approach, find evidence of order flow related determinants of exchange rates. Lyons (2001) proposes limits to the speculation hypothesis and demonstrates that order flow information may reveal additional insights into the forward premium puzzle. Acta Wasaensia 9 The second essay is most closely related to the risk-based explanations of carry trade excess returns, which attempts to explain the forward premium puzzle through the identification of a convenient time-varying risk premia. The inability of conventional risk factors to indisputably reconcile the puzzle as evident in Burnside, Eichenbaum, and Rebelo (2011), has spurred a number of original currency-specific interpretations. Lustig, Roussanov, and Verdelhan (2011) adopt a Fama and French (1993) style approach to forward-sorted currencies and find heterogeneity in exposures to common risks across portfolios, related to rational risk premia. In a similar vein, Menkhoff, Sarno, Schmeling, and Schrimpf (2012a) demonstrate that global currency market volatility shocks exert a compelling pricing power in the cross-section of carry trade returns. Rafferty (2012) indicates that global foreign exchange market skewness is also a valid risk factor. Mancini, Ranaldo, and Wrampelmeyer (2013) and Karnaukh, Ranaldo, and Söderlind (2015) reveal the substantial role of currency market liquidity in explaining the carry trade strategy payoffs. Hassan (2013) and Martin (2013) adopt theoretical models to argue that the spread between two countries’ currency returns is related to the size of the countries. Jylhä and Souminen (2011) show that hedge fund capital flows affect interest rates and exchange rates, in turn affecting carry trade profitability, in a manner consistent with the risk-based explanation. Ready, Roussanov, and Ward (2015) in the model of equilibrium show that heterogeneity in excess returns between high and low interest rate currencies arises from the differences in composition of the trade balance. Bakshi and Ponayotov (2013) document the predictive role of commodities in explaining the time-series of carry trade returns. Lettau, Maggiori, and Weber (2014) argue that investment currencies exhibit large beta loadings conditional on the state of the market, particularly in times of market downturn. Correspondingly, Jurek (2014) shows that returns on a short put position in such currencies explain carry trades. Daniel, Hodrick and Lu (2015), however, find no evidence of downside risk in dollar-neutral carry trades. Ranaldo and Söderlind (2010) find that low interest rate currencies serve as a hedge against market turmoil, appreciating when the aggregate risk is high. Mueller, Stathopoulos, and Vedolin (2015) find a counter cyclicality in cross- sectional correlation dispersion between high and low carry trade currencies which is consistent with the rational risk premia interpretation. Finally, Koijen, Pedersen, Moskowitz, and Vrugt (2012) provide a comprehensive overview of carry trade strategy in different markets and reviews of research within the area. However, none of the above papers investigated the existence of risk premia in the foreign exchange market, as the second essay of the current dissertation does. Despite the abundance of research searching for rational risk premia, only a few studies have attempted to explain forward bias as a risk premium originating 10 Acta Wasaensia from political risk. Bachman (1992) shows that political regime changes between 1973 and 1985 in the major developed countries could affect forward bias. Bernhard and Leblang (2002) argue that democratic processes (in eight industrial countries between 1974 and 1995) distorted forward rate forecasting ability, and thereby contributed to resolving the forward premium puzzle. Capitalizing on previous evidence, the current research adopts a large set of carry trades (48 currencies over the period 1985–2013) and investigates a comprehensive set of political risk components with the goal of comprehending the determinants of carry trade returns and, therefore, forward bias. The third essay takes a step on this path by examining the effect of political risk on individual currency carry trades. Finally, several studies investigate the investment properties of currency carry trades and show that diversification across several currencies leads to carry trade risk reduction. Burnside Eichenbaum, Kleshchelski, and Rebelo (2006) show that the Sharpe ratio generated by an equally weighted portfolio of carry trade strategies is positive and statistically different from zero. Continuing their research Burnside, Eichenbaum, and Rebelo (2008) find that diversification among currencies boosts the Sharpe ratio. An equally weighted carry trade portfolio appears to provide a higher Sharpe ratio and other benefits of diversification in comparison to individual carry trade strategies and stock market benchmark. Inter alia, Burnside, Eichenbaum, and Rebelo (2011) and Bakshi and Panayotov (2013) show that returns are better for portfolios of currencies and that diversification leads to a higher Sharpe ratio and reduction in volatility, implying that diversification across currencies is the key factor in portfolio feature adjustment. The fourth essay of this dissertation is related to this strand of literature and investigates linkages between major carry trade currencies along with carry trade diversification opportunities. 3.2.2 Currency momentum and market liquidity Similar to the carry trade strategy, currency momentum is the prominent foreign exchange market anomaly, which yields significant returns of around one percent per month, due to exploitable disparities in macroeconomic parity conditions (Menkhoff, Sarno, Schmeling, and Schrimpf, 2012b). Currency momentum strategy is executed by taking a long position in currencies with high excess returns in the preceding month(s) and a short position in currencies with low past excess returns. Similar to stock momentum, past winners tend to record positive excess returns while past losers exhibit negative return continuation, resulting in a profitable long-short investment strategy. Acta Wasaensia 11 Contrary to the literature on currency carry trades, there is little research on momentum strategy in the foreign exchange market. Asness, Moskowitz, and Pedersen (2013) document the existence of positive returns on momentum strategy in the cross section of currencies. Burnside, Eichenbaum, and Rebelo (2011) find that neither traditional risk factors nor currency-specific risk factors are able to explain returns on currency momentum strategy. Menkhoff, Sarno, Schmeling, and Schrimpf (2012b) find that currency momentum returns do not exhibit any interactions with standard proxies for currency market illiquidity, currency market volatility, or business cycles. In addition, currency momentum is found to be uncorrelated with carry trade, which creates a hurdle providing a common explanation for the two currency strategies. The first essay bridges the evidence on currency momentum with the literature on equity momentum and market state conditions. Avramov, Cheng, and Hameed (2015), examining equity market states interactions with stock momentum, show that market illiquidity is able to explain variation in stock market momentum payoffs. Cooper, Gutierrez, and Hameed (2004) show that past performance of the market index also predicts equity momentum payoffs. Wang and Xu (2010) point out that equity momentum returns are lower following periods of high market volatility. Pastor and Stambaugh (2003) find that equity illiquidity explains payoff realizations of stock momentum and guide future research to explore how the equity illiquidity affects other markets and various pricing anomalies therein. The first essay follows this guidance and examines the predictive role of equity market illiquidity and other equity market states in explaining the variations in currency momentum payoffs. Second, the first essay is closely related to the two literature strands on foreign exchange market liquidity, and on cross-market linkages between equity and foreign exchange markets. Perhaps, due to issues of data availability, research on foreign exchange market illiquidity has emerged only recently. Early research approached FX illiquidity using the bid-ask spreads component of transaction costs (Bollershev and Melvin, 1994; Bessembinder, 1994). Evans and Lyons (2002), Breedon and Vitale (2010), Breedon and Ranaldo (2012), and Banti, Phylaktis and Sarno (2012) approach FX illiquidity from the market microstructure perspective and argue that order flow can explain a substantial part of exchange rate variations. Mancini, Ranaldo, and Wrampelmeyer (2013) show that liquidity risk explains carry trade returns, and also report the presence of a liquidity risk premium around the time of the 2008 financial crisis. Karnaukh, Ranaldo and Söderling (2015) develop a systematic FX illiquidity measure and advance the understanding of both supply-side and demand-side determinants of variations in currency illiquidity by analyzing a large set of 12 Acta Wasaensia currencies over a long period. Brunnermeier, Nagel, and Pedersen (2008) argue that FX liquidity, driven by supply-side factors attributed to funding illiquidity, is associated with risk premia in foreign exchange. In addition, a number of studies provide evidence of cross-market linkages between equity and foreign exchange markets. Brandt, Cochrane, and Santa- Clara (2006) empirically combine stock markets, risk-free assets and exchange rates in their international risk sharing estimations. Pavlova and Rigobon (2007) highlight the examples of independence across stock, bond, and foreign exchange markets. Kamara, Lou, and Sadka (2008) suggest that equity market conditions affect institutional investors’ trading patterns, which in turn results in commonality across markets. Menkhoff, Sarno, Schmeling, and Schrimpf (2012a) provide evidence that the condition of the forex market, the state of global FX volatility, affects other asset markets, and also prices a cross section of equity momentum and corporate bonds. Filipe and Suominen (2014) show that equity market states in Japan affect currency markets and currency trading, and also expose various channels through which the Japanese stock market conditions significantly affect the lending ability banks, the funding risk of yen carry traders, and the carry trade anomaly itself. However, none of the above papers empirically investigates the role of equity market illiquidity in the foreign exchange market, something the first essay of this dissertation does. Acta Wasaensia 13 4 SUMMARY OF THE ESSAYS This dissertation comprises the four essays described below. The individual contribution of each co-author of essays is as follows: Essay 1: The essay is single-authored by Vitaly Orlov. Essay 2: The essay is single-authored by Vitaly Orlov. Essay 3: The main author of the essay is Vitaly Orlov, who is responsible for the research idea, research design, data collection, empirical analysis, and writing the essay. The role of Mr. Dimic and Dr. Piljak lay in giving valuable comments and suggestions for developing and improving the paper. Essay 4: The main author of the essay is Vitaly Orlov, who is responsible for the research idea, research design, data collection, empirical analysis, and, partially, writing the essay. Professor Äijö contributed with valuable comments and suggestions, shared responsibility for writing the essay, and supervised the process of publishing the paper. 4.1 Currency momentum, carry trade, and market illiquidity The first essay of the dissertation investigates the role of equity market illiquidity in explaining the inter-temporal variations in returns of currency momentum and carry trade strategies. In addition to equity market illiquidity, the essay also examines the predictive role of other market state, namely market volatility and market downturn. In addition, this study concurrently investigates the effects of foreign exchange market illiquidity and equity market illiquidity. Finally, the essay provides evidence on currency market anomalies payoff realizations and interaction with equity market conditions over the most recent decade, one of relatively liquid markets. International finance literature has devoted considerable attention to currency market anomalies, however, there is a little evidence on the issue of liquidity in the foreign exchange market. At the same time, equity market liquidity, along with its relationship with various anomalies in the equity and other financial markets has been extensively studied. Equity market illiquidity is found to explain payoff realizations of various pricing anomalies in the stock market (see, e.g., Pastor and Stambaugh, 2003; Acharya and Pedersen, 2005; and Avramov, 14 Acta Wasaensia Cheng, and Hameed, 2015), the government and corporate bond markets (see, e.g., Fleming and Remolona, 1999; and Bongaerts, de Jong, and Driessen, 2012), and empirically helps to explain returns on commodities and on hedge funds (see Amihud, Mendelson, and Pedersen, 2005). Pastor and Staumbagh (2003) find that equity illiquidity explains payoff realizations of stock momentum and recommend future research explores how the equity illiquidity affects other markets and various pricing anomalies therein. However, despite its importance, there is little evidence available on the cross-market links between currency anomalies on the one hand and stock market conditions on the other. Therefore, the aim of this paper is to fill this gap and to provide new evidence for the predictive role of equity market illiquidity in explaining the variations in currency anomalies. The data sample examined in this study consists of 48 currencies and stretches back to 1976. Following recent studies (e.g., Burnside, Eichenbaum, and Rebelo, 2011; and Menkhoff, Sarno, Schmeling, and Schrimpf, 2012b), we extend the dataset back to 1976 by complementing Barclays data quoted against the U.S. dollar (data become available from October 1983) with historical Reuters data quoted against the British Pound (available from January 1976), subsequently converting these additional quotes against the U.S. dollar. Doing so opens up a larger cross-section of currencies and longer time series essential for the analysis. Taken together the empirical findings of this paper support the notion that equity market conditions affect speculative strategies in the foreign exchange market. The results of this paper indicate that dollar-based currency momentum profitability depends on the level of aggregate equity market illiquidity. Returns on currency momentum are low (high) following months of high (low) equity market illiquidity. In other words, aggregate equity market illiquidity explains the evolution of currency momentum payoffs, but the equity illiquidity effect is found to be fairly inconspicuous in currency carry trade returns. Moreover, the economic impact of the illiquidity effect is substantial, as one standard deviation increase in equity market illiquidity reduces profit by 0.303% per month, which approximates in value to one-third of average monthly profits. The effect of equity market illiquidity dominates other measures of equity market conditions. In addition, the results indicate the reversal in predictability patterns in the most recent decade due to structural and technological changes. Finally, the predictive effect of equity market illiquidity on currency momentum returns is robust to the alternative equity illiquidity specification and persists after controlling for aggregate foreign exchange market liquidity, and also sustains a number of robustness checks. In light of the findings, this paper significantly expands the Acta Wasaensia 15 existing literature by revealing novel evidence on the effect of equity market illiquidity on the currency market. 4.2 Solvency risk premia and the carry trades The second essay examines the risk-return characteristics of the currency carry trade strategy and rationalizes the strategy returns as a compensation for common risk. There is abundant evidence suggesting the existence of common determinants of inter-temporal variations in carry trade returns, which lends support to a rationalization of strategy returns as a compensation for common risk. This implies that there are persistent differences in global risk exposures across countries and this heterogeneity is the source of carry trade profitability. The second essay sheds light on a possible origin of such heterogeneity and offers a new risk-based explanation for currency risk premia wherein currency carry trades can be rationalized by the time-varying risk premia originating from the sovereign solvency risk. Hinging on classic asset pricing procedures the second essay introduces a new, solvency-based risk factor and shows that its covariance with returns accounts for almost all cross-sectional variation across portfolios. The main avenue for research perceives carry trade returns as a compensation for a common risk. Accordingly, currencies are prone to deliver low/high carry trade returns in bad/good times due to persistent heterogeneity in risk exposures between investment and funding currencies. Several recent studies suggest a number of possible explanations for observed patterns of heterogeneous risk exposures (see, e.g., Lustig, Roussanov, and Verdelhan, 2011; Menkhoff, Sarno, Schmeling, and Schrimpf, 2012a; Lettau, Maggiori, and Weber, 2013). Overall, the cumulative evidence points to time-varying risk premia as the pervasive source of the carry trade returns and to the forward premium puzzle not being without costs. The purpose of the paper is to contribute toward the identification of an appropriate risk premia that explains the carry trade profitability. Importantly, this essay abstracts from the market measures of country’s creditworthiness and relies on fundamentals. Several recent studies identify the marginal value of sovereign CDS spreads in interpreting the forward premium puzzle around the financial crisis as being broadly consistent with the crash risk explanations (see, e.g., Hui and Chung, 2011; Coudert and Mignon, 2013; Huang and MacDonald, 2014). Along with that, there is also evidence that market-based measures (CDS spreads) do not offer a true prediction of financial distress, if they contain country-specific information at all and that sovereign CDS spreads are plagued by time-varying systemic risk, global risk premia and other global and 16 Acta Wasaensia regional economic forces, while exhibiting almost no evidence of sovereign- specific credit risk premia (see, e.g., Mauro, Sussman, and Yafeh, 2002; Pan and Singleton, 2008; Longstaff, Pan, Pedersen, and Singleton, 2011; and Ang and Longstaff, 2013). Capitalizing on that evidence, this study considers the fundamental measures of the financial competence of the economy. Therefore, in this essay the sovereign solvency risk depends upon a country’s ability to repay an outstanding external debt. In addition, the second essay proposes a new risk-adjusted version of uncovered interest parity. Bridging the macroeconomic concepts of the debt-elastic interest rate and risk premium associated with lending to the economy, the paper derives the uncovered interest parity condition that is disturbed by country-specific risk premia given by the increasing convex function of the debt service capacity of the economy. Therefore, time-varying solvency risk premia offset the disparity between actual and expected exchange rate, establishing equilibrium. This provides a simple and intuitive risk-based view on exchange rate determination by a risk premium varying in the solvency of the economy. The empirical findings of the second essay indicate that solvency risk retains substantial power to explain the cross-section of carry trade returns. This paper introduces a new, solvency-based, risk factor and shows that its covariance with returns accounts for almost all of the variation in the cross-section of carry trade returns. The empirical approach builds on the classic APT way of explaining the cross-section of carry trade returns and identifies persistent heterogeneity in loadings on a common component across countries’ pricing kernels, relying on much of the recent literature (Lustig, Roussanov, and Verdelhan, 2011; and Ready, Roussanov, and Ward, 2015). The results indicate that the solvency sorted and forward discount sorted portfolios are exposed to a risk of a common origin that spurs the heterogeneity in average excess returns. In line with that finding, the heterogeneous risk exposures of currencies reveal that low carry trade currencies serve as a hedge against solvency risk, while high carry trade currencies depreciate, exposing investors to more risk and requiring a higher risk premium. The IMS factor (returns on zero-cost indebted-minus-solvent economies strategy) explains the substantial part of the cross-sectional variation in carry trade portfolios, exhibiting monotonically increasing factor loadings and significant prices of risk, consistent with risk premia explanation. Moreover, the factor is empirically powerful in various model specifications and sample splits, prices different test assets, stands out in competition with other currency-specific risk factors, robust against an alternative funding currency (the Japanese Yen) and alternative solvency measure specifications, and passes several other Acta Wasaensia 17 robustness checks, pointing to the solvency risk factor being a persuasive tool for pricing the cross-section of carry returns. 4.3 The effect of political risk on currency carry trade The third essay explores the risk profile of individual currency carry trades and investigates whether currency carry trade profitability depends on a country’s political risk characteristics. In doing so, the essay considers a comprehensive set of political risk components together with a large set of individual carry trades and aims to elicit the determinants of carry trade returns and, therefore, of forward bias. Although the risk-based explanations of carry trade profitability is a renowned topic in the international finance literature, very few studies consider a country’s political risk characteristics in attempting to explain currency carry trades (see, e.g., Bachman, 1992; and Bernhard and Leblang, 2002). This essay aims to contribute to filling this gap. The studied sample comprises currency data and political risk measure in the form of annual rating scores for 48 countries. The sample period spans 01/1985 to 12/2013. Data on the political risk measure and its components is acquired from the International Country Risk Guide of the Political Risk Services Group. In addition, the components of political risk are organized into four subgroups as in Bekaert, Harvey, Lundblad, and Siegel (2014), those subgroups being: quality of institutions, conflicts external/internal, democratic tendencies, and government actions. The findings of the third essay indicate that political risk may contribute to the existence of the forward premium puzzle. Scrutinizing a comprehensive currency universe, composite political risk and the set of political risk components, this study shows that individual carry trade profitability depends on a country’s political risk. In particular, carry trade returns are high (low) when political risk is high (low). In addition, the results indicate that the political risk effect originates in emerging economies, while it is not evident in developed countries. Similarly, Erb Harvey, and Viskanta (1996) and Dimic, Orlov, and Piljak (2015), also document the increasing importance of political risk for the financial markets of emerging economies. Further, the paper documents how only the competence of government actions as a stand-alone component of political risk endures the adjustment for common risk factors. Finally, political risk is priced only in the subsample of high interest rate differential countries. To sum up, evidence suggests that individual carry trades are heterogeneously exposed to 18 Acta Wasaensia political risk and currency carry trade profitability depends on a country’s political risk characteristics, thus providing new support for the risk-based view on the forward premium puzzle. Overall, the evidence points to individual carry trades having different exposures to political risk across market categories and across currencies sorted by forward discounts. However, the economic magnitudes are not high enough to claim that political risk completely explains the forward premium puzzle. Nevertheless, the findings of this paper lend support to the point of view that political science theory can provide insights into financial market anomalies, and suggest that future research should not neglect information on fundamental political processes. 4.4 Benefits of wavelet-based carry trade diversification The fourth essay of this dissertation investigates currency carry trade diversification opportunities and the links between major carry trade currencies on five different investment horizons, by applying a maximum overlap discrete wavelet transform method. This advantageous technique supports performing scale-to-scale decomposition to assess the temporal and dynamic structure of exchange rate correlations, which provides an opportunity for thorough investigation of the carry trade diversification opportunities and the inter- dependences of the currencies. Recent studies indicate that aggregation of currencies in portfolios helps increase the investment properties of currency carry trades, thus, implying that diversification across currencies is an important factor in portfolio construction (see, e.g., Burnside, Eichenbaum, and Rebelo, 2011; and Bakshi and Panayotov, 2013). At the same time, Nekhili, Aslihan, and Gencay (2002) indicate the importance of scale-based analysis in maximizing diversification benefits. In addition, the wavelet analysis of financial time series and maximum overlap discrete transform techniques have been used extensively to study the co- movements dynamics of stock markets (see, e.g., Graham and Nikkinen, 2011; Graham, Kiviaho, and Nikkinen, 2012; and Nikkinen, Piljak, and Äijö, 2012). The fourth essay bridges these strands of the literature to investigate links between major carry trade currencies and explore the diversification properties of carry trades. The empirical findings reported in the fourth essay indicate that positive and economically significant excess returns are observed on different investment horizons, namely the one-day, one-week, one-month, quarterly, and yearly Acta Wasaensia 19 horizons. In addition, results demonstrate that portfolio composition on the basis of wavelet correlations of returns with dynamic re-balancing leads to Sharpe ratios higher than the simply diversified portfolios and stock market proxy on most of the time scales. These results are more pronounced in the pre-crisis period. Wavelet diversified portfolios have better skewness-return characteristics on a three-month time scale, showing more positive skewness than individual carry trade strategies while posting similar returns. In addition, the wavelet diversification approach seems to perform better on longer time scales (from one-month upward) in a low volatility environment rather than on short horizons in a highly volatile market. 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Box 700, FI-65101 Vaasa, Finland a r t i c l e i n f o Article history: Received 29 May 2015 Accepted 23 February 2016 Available online 2 March 2016 JEL classification: F31 G15 Keywords: Currency momentum Carry trades Market illiquidity a b s t r a c t This study empirically examines the effect of equity market illiquidity on the excess returns of currency momentum and carry trade strategies. Results show that equity market illiquidity explains the evolution of currency momentum strategy payoffs, but not carry trade. Returns on currency momentum are low following months of high equity market illiquidity. However, in the recent decade, illiquidity positively predicts the associated payoffs. The findings withstand various robustness checks and are economically significant, approximating in value to one-third of average monthly profits. � 2016 Elsevier B.V. All rights reserved. 1. Introduction International finance literature has devoted considerable atten- tion to currency market anomalies over the last three decades. However, only recently advances have been made on the issue of liquidity in the foreign exchange market. At the same time, equity market liquidity, along with its relationship with various anoma- lies in the equity and other financial markets has been extensively studied.1 However, despite its importance, there is little evidence available on the cross-market links between currency anomalies on the one hand and stock market conditions on the other.2 This paper aims for contributing towards filling this gap. Accordingly, the current research investigates the role of equity market illiquidity and other equity market states in explaining the inter-temporal variations in returns of currency momentum and carry trade strategies. Currency momentum and carry trade strate- gies have long been known to yield significant excess returns, owing to exploitable disparities in macroeconomic conditions. Recent research reports the time-series dependence of carry trade payoffs on business cycles, stock market volatility, and on liquidity of the foreign exchange market (see Ranaldo and Soderlind, 2010; Christiansen et al., 2011; Menkhoff et al., 2012a; Mancini et al., 2013; Daniel et al., 2015). Other studies suggest that equity market conditions and equity-based funding risk measures may explain a proportion of currency carry trade returns (see Gromb and Vayanos, 2002; Hattori and Shin, 2009; Brunnermeier and Pedersen, 2009; Filipe and Suominen, 2014; Banti and Phylaktis, 2015). At the same time, Menkhoff et al. (2012b) find that currency momentum returns do not exhibit any interactions with standard proxies for currency market illiquidity (further FX illiquidity), http://dx.doi.org/10.1016/j.jbankfin.2016.02.010 0378-4266/� 2016 Elsevier B.V. All rights reserved. q Author is grateful for the comments and suggestions of the two anonymous referees, Lars Lochstoer, Doron Avramov, Mikko Leppämäki, Daniel Buncic (discus- sant), Tai David Yi (discussant), Sean Yoo (discussant), Janne Äijö, Sami Vähämaa and thanks seminar participants at Aalto School of Economics, Columbia Business School, the NHH EAP December 2014 workshop, the 2014 Australian Finance and Banking Conference, the 2015 Midwest Finance Association Annual Meeting, the 2015 Eastern Finance Association Annual Meeting for providing valuable com- ments. The paper was partially written while V. Orlov was a Visiting Scholar at the Columbia Business School. Author gratefully acknowledges financial support from the OP-Pohjola Group Research Foundation (grant 201500087). ⇑ Tel.: +358 41 700 8227. E-mail address: vorlov@uva.fi 1 Equity market illiquidity is found to explain payoff realizations of various pricing anomalies in stock market (see, e.g., Pastor and Stambaugh, 2003; Acharya and Pedersen, 2005; Avramov et al., 2015), government and corporate bond market (see, e.g., Fleming and Remolona, 1999; Bongaerts et al., 2012), and empirically helps to explain returns on commodities and on hedge funds (see Amihud et al., 2005). 2 A number of studies provide evidence on cross-market linkages between equity and foreign exchange markets. Brandt et al. (2006) empirically combine stock markets, risk-free assets and exchange rates in their international risk sharing calculations. Pavlova and Rigobon (2007) highlight the examples of independence across stock, bond, and foreign exchange markets. Kamara et al. (2008) suggest that equity market conditions affect institutional investors’ trading patterns, which in turn results in commonality across markets. Journal of Banking & Finance 67 (2016) 1–11 Contents lists available at ScienceDirect Journal of Banking & Finance journal homepage: www.elsevier .com/locate / jbf Acta Wasaensia 27 currency market volatility, or business cycles. Pastor and Stambaugh (2003) find that equity illiquidity explains payoff real- izations of stock momentum and guide future research to explore how the equity illiquidity affects other markets and various pricing anomalies therein. This study takes a step on that path and pro- vides new evidence for the predictive role of equity market illiq- uidity in explaining the variations in currency momentum payoffs. The empirical findings of this paper support the notion that equity market conditions affect speculative strategies in the for- eign exchange market. We find that dollar-based currency momen- tum profitability depends on the level of aggregate equity market illiquidity. The full-sample investigation reveals that returns on the momentum long-short strategy are lower following months of high equity market illiquidity, and vice versa, strategy records high profits when the market is liquid. Moreover, the economic impact of the illiquidity effect is substantial, as one standard devi- ation increase in equity market illiquidity reduces profit by 0.303% per month, which approximates in value to one-third of average monthly profits. In addition, the dominant predictive role of equity market illiquidity stands out after controlling for other dimensions of market conditions.3 Further, we find that the equity market illiquidity-carry trade relation is not robust, as it is dominated by FX market illiquidity and is attenuated by the introduction of alter- native measure of illiquidity and other robustness checks. The analysis is then extended to high and low illiquidity peri- ods. Findings suggest the substantive ability of equity market illiq- uidity to predict returns on a currency momentum strategy, but the predictive effect is reversed in the two sample periods. In the period of high illiquidity (1976–2001), months of high (low) equity market illiquidity are followed by low (high) profits on the momentum strategy. Conversely, we find that in the recent decade of low illiquidity (2001–2012) equity market illiquidity positively predicts payoffs of currency momentum, in that returns on the strategies are high (low) following months of high (low) equity market illiquidity. We suggest that the observed divergence in pre- dictability patterns is due to structural and technological changes in the most recent decade, which resulted in lower trading costs, increased market liquidity, a decreased role for funding liquidity, along with an overall increase in the salience of the currency anomalies (see French, 2008; Chordia et al., 2014). These results are only partially confirmed for the carry trade anomaly; that is, the sign of the effect for the carry trade strategy is analogous to its momentum counterpart, but the coefficient estimates only occasionally verge on significance, reflecting the differences between the anomalies. Additionally, we expand our analysis in a number of directions. First, we show that the equity illiquidity effect on the currency momentum strategy is not subsumed by FX market illiquidity. Sec- ond, the main results of the paper hold true when we consider an alternative measure of equity market illiquidity as measured by Corwin and Schultz (2012) and perform sample split tests. Third, we show that results withstand several robustness checks. Specif- ically, the equity market illiquidity-momentum relationship is evi- dent in portfolio returns with various formation periods and on the level of individual currencies, persists in different sample periods, endures after adjusting for traditional and currency-specific risk factors, transaction cost, currency tradability, and also sustains other robustness checks. This study contributes to the literature in several important ways. First, we extend the strand of the literature on return pre- dictability of currency anomalies. We provide new evidence on return predictability and add to the findings of studies, such as those of Bacchetta and van Wincoop (2010), Ranaldo and Soderlind (2010), Christiansen et al. (2011) and Menkhoff et al. (2012a), by exposing the predictive role of equity market illiquid- ity in explaining the inter-temporal variations in currency momen- tum returns. Further, our findings address Burnside’s (2008) critique that literature on predictability is segmented across mar- kets, as Amihud’s (2002) illiquidity is also found to explain payoff realizations of equity pricing anomalies. Second, the finding indi- cating that equity market illiquidity negatively predicts profitabil- ity during the high-illiquidity period provides additional support for the theoretical work of Brunnermeier and Pedersen (2009) and Filipe and Suominen (2014) that links market liquidity and funding liquidity. Third, we add to the studies on recent trends in market anomalies (see Chordia et al., 2011; Brogaart et al., 2014; Chordia et al., 2014) by providing evidence on currency mar- ket anomalies payoff realizations and interaction with equity mar- ket conditions over the most recent decade. Finally, this study provides additional support to the prior literature that documents the linkage between equity and foreign exchange markets (e.g., Hau and Rey, 2006; Korajczyk and Viallet, 1992; Filipe and Suominen, 2014). The remainder of the paper is organized as follows. In Sec- tion 2, we describe the dataset, predictive variables, the portfolio formation process, and provide descriptive statistics. In Section 3, we turn to the relation at the center of the current study and examine the predictive role of equity market illiquidity in portfo- lio returns. Several robustness checks are reported in Section 4, and Section 5 concludes the paper. This paper is accompanied with the Internet Appendix that provides results of additional robustness checks. 2. Data 2.1. Data sample The sample consists of end-of-month observations of spot exchange rates, one-month forward exchange rates, and corre- sponding bid-ask spreads for the period from January 1976 to Jan- uary 2014. The dataset was obtained from Barclays and Reuters via Datastream and comprises the currencies of the following 48 terri- tories: Australia, Austria, Belgium, Brazil, Bulgaria, Canada, Croatia, Cyprus, Czech Republic, Denmark, Egypt, the Euro area, Finland, France, Germany, Greece, Hong Kong, Hungary, India, Indonesia, Ireland, Israel, Italy, Iceland, Japan, Kuwait, Malaysia, Mexico, Netherlands, New Zealand, Norway, Philippines, Poland, Portugal, Russia, Saudi Arabia, Singapore, Slovakia, Slovenia, South Africa, South Korea, Spain, Sweden, Switzerland, Taiwan, Thailand, Ukraine, and United Kingdom. Throughout the studied period, the effective sample size varies greatly due to the availability of data quotes. The total number of end-of-month (not averaged over month) observations is 13,163. Following recent studies (e.g., Burnside et al., 2011; Menkhoff et al., 2012b), we extend the dataset back to 1976 by complement- ing Barclays data quoted against the U.S. dollar (data become avail- able from October 1983) with Reuters data quoted against the British Pound (available from January 1976), subsequently con- verting these additional quotes against the U.S. dollar. Doing this allows us to obtain the larger cross-section of currencies and longer time series essential for further analysis. In addition, in the Internet Appendix, we consider a smaller sample by excluding particular observations when trading was not possible and, even, completely exclude currencies with non-deliverable forward trad- ing in offshore markets. 3 Alongside the aggregate illiquidity measure, we also consider an aggregate market volatility measure (Wang and Xu, 2010) and a negative market returns measure (Cooper et al., 2004). 2 V. Orlov / Journal of Banking & Finance 67 (2016) 1–11 28 Acta Wasaensia 2.2. Currency excess returns In this study we construct currency excess returns in a classic way, adopting the perspective of a U.S. investor, so that the monthly excess return for holding foreign currency i is defined as: ritþ1 ¼ iit � it � Dsitþ1 � f it � sitþ1 ð1Þ where iit and it stand for the foreign and domestic (U.S.) interest rates in month t, respectively, and the interest rate differential is approximately equal to the log forward discount under a covered interest parity condition. f it denotes the log one-month forward rate in units of foreign currency i per U.S. dollar in month t and si is the log spot exchange rate. In order to account for transactions costs, we compute the log currency excess returns net of bid-ask spreads. For this purpose we employ bid-ask quotes from Reuters. Lyons (2001) shows that these quotes are of a magnitude almost double inter-dealer spreads, but, fortunately, they do not exhibit any lag effects on monthly frequency. Hence, our bid-ask spreads can be viewed as realistic, if perhaps overly vigilant. Log net excess returns are fur- ther applied in portfolio construction (momentum and carry trade). The log monthly net excess return to an investor who takes the long position in foreign currency is therefore: rlongtþ1 ¼ f bt � satþ1 ð2Þ where the letters b and a indicate bid and ask quotes, respectively. In this case the investor buys the foreign currency in the forward market at the bid price and, subsequently, sells the foreign currency at the ask price in the spot market. In a similar vein, the log monthly net excess return if an investor goes short on foreign currency is: rshorttþ1 ¼ �f at þ sbtþ1 ð3Þ 2.3. Portfolios Our portfolio formation approach is similar to Lustig et al. (2011) and Menkhoff et al. (2012b). To form momentum and carry trade portfolios at the end of each month t, we allocate currencies to one of six groups based on their lagged excess returns and lagged forward discount, respectively. Currency excess returns over the previous one, six, and twelve-months periods are used to sort currencies into momentum sextiles, while one-month lagged forward discounts are used to construct carry trade portfo- lios. In both cases, portfolios are held for one month and rebal- anced on a monthly basis. The top (bottom) sextile of currencies constitutes the ‘‘High” (‘‘Low”) portfolios. Thus, one-sixth of all cur- rencies with the highest lagged excess returns (forward discounts) are placed into the sixth portfolio (‘‘High”) in case of momentum (carry trade). In a similar manner, the first portfolio comprises one-sixth of all currencies with the lowest lagged excess returns (forward discount). Finally, the portfolio holding period return in month t is the equally-weighted sum of currency excess returns in each sextile. Overall, six portfolios are used in evaluating the momentum and carry trade strategies. To build the time series of momentum and carry trade payoffs, we go long in the winner portfolio (sixth portfolio) and go short in the loser (first portfolio). In order to account for transaction costs, we assume that currency speculators short all foreign currencies in the first portfolio, while taking the long position in the remainder. These portfolios are referred to as ‘‘high-minus-low”, ‘‘long-short” or ‘‘winner-minus-loser” portfo- lios. It is noteworthy that the number of currencies in the portfo- lios varies greatly over the period. We start with 16 currencies available at the beginning of 1976 and finish with 43 currencies by the end of 2013. The minimum number of currencies is nine at the end of 1983. 2.4. Momentum and carry trade returns First, we provide an overview of the currency portfolios without transaction costs. Table 1 (Panels A and B) presents descriptive statistics of average monthly profits of the momentum and the carry trade portfolios over the full sample period. We also report maximum and minimum values, standard deviation of returns, skewness, kurtosis, and the Sharpe ratio, in addition to alphas (as a percentage) adjusted with various traditional and unconven- tional risk factor models. Panel A of Table 1 presents the characteristics of six momentum portfolios formed on the basis of a one-month formation period and a one-month holding period. We find that the high portfolio outperforms the low portfolio to yield a substantial full-sample average monthly high-minus-low (H-L) portfolio return of 1.09 percent. Consistent with the existing literature, these momentum profits are not due to exposure to traditional or currency-specific risk factors. Specifically, the CAPM-adjusted H-L portfolio return increases to 1.16 percent per month. Similarly, the Fama–French three-factor-adjusted high-minus-low return is also significant at 1.16 percent per month. Turning to currency-based risk factor models, we report the 0.10 percent per month decrease in return after adjusting for the dollar risk factor (the average excess returns to all of the portfolios) and the HMLfx (the long-short carry trade return) risk factor derived from Lustig et al. (2011). The returns are further adjusted with the Menkhoff et al. (2012a) model, which results in a slight decrease in returns. Overall, currency-based risk factors also fell short in explaining currency momentum profits.4 Panel B of Table 1 shows descriptive statistics for six carry trade portfolios. We find that the average raw return for the high-minus- low carry trade portfolio is highly significant at 1.04 percent per month. Similar to the currency momentum profits, adjustments for common risk factors do not significantly change carry trade payoffs. In this panel, we consider only traditional risk based mod- els as currency-specific factors to a large extent constructed to explain the returns on carry trade. Table 1 also presents other characteristics of the portfolios, including standard deviation, skewness, kurtosis, and the Sharpe ratio. These descriptive statistics are intended to address the con- cern that momentum and carry trade, being the two most promi- nent currency speculative strategies, capture the same information. As can be seen above, both strategies demonstrate similar patterns in portfolio returns. However, the distribution of these returns is in fact very different. For instance, the momentum payoff is positively skewed (0.70), while the carry trade profit exhi- bits negative skewness (�0.68), suggesting that carry trade strat- egy comes with occasional crashes.5 2.5. Aggregate market state variables The following empirical part of this paper mainly focuses on the role played by aggregate market liquidity in explaining the time variation in currency momentum and carry trade payoffs. We uti- lize Amihud’s illiquidity as our main measure of aggregate market liquidity. Although, our analysis focuses on the role of aggregate liquidity, it is important to consider other dimensions of market states. We therefore compute a dummy for a negative cumulative 4 We are grateful to Kenneth French for making common risk factors publicly available. 5 For a more comprehensive comparison of currency momentum and carry trade returns see Menkhoff et al. (2012b). For more evidence on carry trade crashes see Brunnermeier et al. (2008). V. Orlov / Journal of Banking & Finance 67 (2016) 1–11 3 Acta Wasaensia 29 two-year stock market return and the measure of aggregate stock market volatility. All of these variables have been found to predict the evolution of stock market momentum payoffs.6 We define the level of aggregate market illiquidity as Amihud’s illiquidity or, simply, illiquidity in the rest of the paper. The measure is constructed in a similar way to that presented by Amihud (2002) and normalized. Specifically, it is the value-weighted average of a monthly Amihud’s (2002) illiquidity measure of each NYSE and AMEX firm for the period from January 1976 to December 2011. The monthly illiquidity measure for a single firm is computed as the absolute value of the daily stock return divided by the daily trading volume of that stock, subsequently aggregated over the number of trading days in the month. The next market state vari- able is a dummy for a negative cumulative two-year stock market return (henceforth, ‘‘the down market”). The dummy variable takes the value of one if the past twenty-four months’ return on the value-weighted CRSP market index is negative and zero otherwise. The volatility measure is calculated as the standard deviation of the value-weighted CRSP market index. Time spans for all three market state variables are matched. Additionally, in most of our analyses we control for potentially systemic macroeconomic events, introducing a dummy variable taking the value of one if a relevant macroeconomic event occurs. Specifically, the list of Table 1 Descriptive statistics for momentum and carry trade returns. Low 2 3 4 5 High Average H-L Panel A: momentum (1,1) Raw returns �0.371⁄⁄ 0.004 0.186 0.200 0.214⁄ 0.716⁄⁄⁄ 0.158 1.088⁄⁄⁄ (�2.38) (0.07) (1.29) (1.43) (1.75) (4.01) (1.14) (6.54) CAPM alpha �0.467⁄⁄⁄ �0.058 0.152 0.156 0.178 0.695⁄⁄⁄ 0.109 1.162⁄⁄⁄ (�2.71) (�0.39) (1.35) (0.97) (1.32) (3.66) (0.69) (6.46) 3-FM alpha �0.486⁄⁄⁄ �0.056 0.152 0.153 0.161 0.676⁄⁄⁄ 0.100 1.162⁄⁄⁄ (�2.67) (�0.36) (0.95) (0.90) (1.13) (3.64) (0.60) (6.24) Lustig’s alpha �0.592⁄⁄⁄ �0.088 0.100 0.109⁄ 0.126⁄⁄ 0.475⁄⁄⁄ 0.022 1.067⁄⁄⁄ (�5.23) (�1.21) (1.58) (1.72) (2.29) (4.30) (0.81) (5.42) Menkhoff’s alpha �0.290 �0.202 �0.386⁄⁄ 0.215 0.049 0.817⁄⁄⁄ 0.051⁄⁄ 1.107⁄⁄ (�1.05) (�0.84) (�2.38) (1.28) (0.27) (2.80) (2.15) (2.19) Max (in %) 13.02 7.87 10.25 8.07 11.34 8.98 6.80 21.25 Min (in %) �17.59 �10.92 �10.07 �9.54 �9.10 �9.95 �8.37 �11.98 Std. Dev. 3.084 2.589 2.661 2.619 2.483 2.783 2.287 3.319 Skewness �0.688 �0.381 �0.186 �0.167 0.025 �0.080 �0.368 0.811 Kurtosis 7.361 5.034 4.347 3.796 4.552 4.167 3.914 7.771 Sharpe ratio �0.120 0.001 0.070 0.076 0.086 0.257 0.069 0.328 Panel B: carry trade Raw returns �0.310⁄⁄ �0.048 0.096 0.167 0.268⁄⁄ 0.733⁄⁄⁄ 0.151 1.043⁄⁄⁄ (�1.98) (�0.38) (0.76) (1.21) (2.00) (3.14) (1.09) (5.26) CAPM alpha �0.344⁄⁄ �0.089 0.056 0.152 0.255⁄ 0.735⁄⁄⁄ 0.137 0.997⁄⁄⁄ (�2.02) (�0.64) (0.40) (1.03) (1.71) (3.18) (0.67) (5.05) 3-FM alpha �0.362⁄⁄ �0.094 0.074 0.114 0.193 0.657⁄⁄⁄ 0.097 1.019⁄⁄⁄ (�2.05) (�0.67) (0.51) (0.72) (1.25) (2.79) (0.58) (4.87) Max (in %) 8.93 8.28 8.84 10.75 7.28 10.62 7.38 12.06 Min (in %) �12.72 �9.52 �8.73 �10.19 �9.59 �17.59 �8.26 �12.55 Std. Dev. 2.777 2.549 2.432 2.526 2.533 3.320 2.307 3.287 Skewness �0.140 �0.077 �0.067 �0.144 �0.527 �0.751 �0.323 �0.676 Kurtosis 4.702 3.968 4.201 5.285 4.467 5.912 3.959 5.259 Sharpe ratio �0.122 �0.019 0.039 0.066 0.106 0.221 0.065 0.317 H-L Amihud’s illiquidity Market volatility Down market Crisis Panel C: Correlation among market states (Momentum profit with f = 1 is used) H-L 1.000 Amihud’s illiquidity �0.110 1.000 Market volatility 0.123 �0.216 1.000 Down market state 0.031 �0.226 0.442 1.000 Crisis 0.090 �0.112 0.183 0.155 1.000 Panel D: Correlation among market states (Carry trade profit) H-L 1.000 Amihud’s illiquidity �0.113 1.000 Market volatility 0.170 �0.216 1.000 Down market state 0.084 �0.226 0.442 1.000 Crisis �0.091 �0.112 0.183 0.155 1.000 This table presents descriptive statistics of average monthly profits of the momentum and the carry trade portfolios. The data period spans January 1976 to January 2014. The currency momentum and the carry trade payoffs are formed with one-month formation period and one-month holding period. In Panel A (Panel B) we report average equally- weighted holding period returns of each sextile portfolio, as well as the average and the momentum (the carry trade) profits (H-L portfolio). H-L denotes the currency momentum (the carry trade) trading strategy profits, where the equally-weighted bottom sextile portfolio (Low) is subtracted from equally-weighted top sextile portfolio (High). Further, we report alphas (in %) by adjusting returns with CAPM, Fama–French three-factor, Lustig et al. (2011) and Menkhoff et al. (2012a) models. We also report maximum and minimum values, standard deviation of returns, skewness, kurtosis, and the Sharpe ratio, computed as average monthly excess portfolio return divided by its standard deviation. Panel C (Panel D) shows the pairwise correlation between the momentum (1,1) strategy (the carry trade strategy) and market state variables, such as Amihud’s illiquidity, down market state, market volatility and crisis control. Newey and West (1987) HAC based t-statistics are presented in parenthesis. Numbers annotated with asterisks ⁄, ⁄⁄ and ⁄⁄⁄ are significant at the 10%, 5% and 1% level, respectively. 6 There is extensive literature on equity momentum and market state conditions. Avramov et al. (2015) show that a market illiquidity state is able to explain some variation in stock market momentum payoffs. Cooper et al. (2004) show that past performance of the market index also predicts equity momentum payoffs. Finally, Wang and Xu (2010) point out that equity momentum returns are lower following high market volatility periods. 4 V. Orlov / Journal of Banking & Finance 67 (2016) 1–11 30 Acta Wasaensia relevant events includes: the devaluation of the Thai baht (1997:07), the Russian default (1998:08), the Icelandic currency crisis (2006:03), the Lehman Brothers collapse (2008:09) and many others.7 Panels C and D of Table 1 show the time-series correlation of market state variables with the high-minus-low momentum and carry trade returns, respectively. Correlation coefficients for both momentum and carry trade payoffs with market level variables are low, ranging from �0.11 to 0.12. In turn, aggregate market state variables are fairly well correlated. It is notable that Amihud’s illiq- uidity proves to have a negative correlation with other predictors. This fact is counter-intuitive and arises owing to the limited period for which data is available, as when the data period was extended back to 1928, the correlations became positive. Additionally, we checked that the autocorrelation is far from 1.0 and that Stambaugh’s (1999) small sample bias is clearly not an issue. 3. Currency momentum, carry trade in portfolio returns, and illiquidity 3.1. Equity market illiquidity and currency anomalies This section presents empirical findings on the predictive power of equity market illiquidity to explain the evolution of currency momentum and carry trade payoffs, while investigating the full sample period. The analysis is based on eight time-series regres- sion specifications, starting from the iid model (intercept only) and concluding with a comprehensive specification, where we con- trol for other dimensions of equity market conditions. In these models, the dependent variable is either currency momentum or carry trade high-minus-low portfolio return, formed on the basis of a one-month formation period and one-month holding period. As the predictive variables, we consider three one-month lagged aggregate equity market state measures, namely, Amihud’s illiq- uidity, a bear market return state, and market volatility. Addition- ally, we control for potentially disturbing macroeconomic events by introducing a crisis control variable. Table 2 reports the coefficient estimates of all regression designs with adjustments for Fama–French common risk factors. All of the models in Panel A include a winner-minus-loser momen- tum return as the dependent variable, while Panel B reports results of analogous models with a high-minus-low carry trade payoff. The data period spans 1976:1 to 2011:12. Estimates of such regressions consistently support the notion that equity market illiquidity explains the inter-temporal variation of currency momentum and, possibly, carry trade payoffs. The slope coefficients of Ami- hud’s illiquidity measure are �0.349 and �0.431 for momentum and carry trade, respectively, and are significant in the specifica- tion with the single predictor (Model 2 in Panels A and B). Further, inclusion of the down market and market volatility variables results in a drop in the coefficients for illiquidity for the two strate- gies and their significance. Noteworthy, the coefficient of Amihud’s illiquidity exhibits only a slight decrease in significance and mag- nitude in the all-inclusive model (Model 8 in both panels), while in the carry trade regression the coefficient value is around 30 per- cent smaller relative to the iid model and significant only at a 10 percent level. Moreover, the illiquidity effect has a considerable economic impact, as one standard deviation increase in equity market illiquidity leads to a 0.303% per month decline in profit for momentum and, if coefficient c