Stock returns and carry trades

Abstract This paper studies the role the stock market plays in determining the carry trade return. Evidence shows stock market returns significantly affect the carry trade returns in Australia, Mexico, Japan, the UK, Sweden, and the Eurozone. This paper further examines three channels through which stock returns affect the carry trade returns: the Balassa-Samuelson, risk-premium, and flight-to-quality effects. Our model shows that the stock market impact on the carry trade return depends on stock market volatility, and the flight-to-quality effect prevails globally. Furthermore, the introduction of the stock return significantly improves the out-of-sample forecast of the carry trade return when the domestic market is volatile.