Essays on Carry Trade and Exchange Rate Forecasting

This thesis is the combination of three papers on carry trade strategies and exchange rate forecasting. The rst paper evaluates the performance of carry trade strategies with implied Taylor rule interest rate di erentials and compares their performance statistics to the naive carry trade strategy with actual interest rates. I argue that the crash risk is reduced with implied Taylor rule interest rate di erentials as a trading strategy in Yen and Franc trades for the whole sample period. During the recent nancial crisis, the carry trading strategies with an implied Taylor rule interest rate perform best in terms of mean returns, risk adjusted returns and downside risk. The second paper evaluates the performance of carry trade strategies with Taylor rule fundamentals in a Markov switching dynamic factor augmented regression framework and compares the performance statistics with the benchmark model of a random walk. I make simulations with the Japanese Yen, Swiss Franc and US Dollar as funding currencies against six target currencies. I argue that risk adjusted returns, mean returns and down-side risk perform best when the Taylor rule is used in a regime switching factor augmented regression framework for Yen and Dollar trades. The results are robust to di erent time periods. In the third paper, I estimate a dynamic factor from the risk premium of bilateral US Dollar against 15 OECD countries, and augment macro fundamentals suggested by Taylor rule, monetary and purchasing power parity models with that factor. I nd evidence of short term predictability of bilateral exchange rates between 1991 and 2012 with factor augmented macro fundamentals.