Predicting foreign investors’ carry trade activity in the Israeli FX market using a time-varying currency risk premium approach

This study investigates the capability of some Carry To Risk (CTR) measures to predict foreign investors' carry trade activity in the Israeli FX market during the period 1/2006 - 12/2014. We propose a new CTR measure based on accumulated time-varying currency risk premiums. The predictive capability of the various CTRs is examined on nonresidents' holdings of Israeli government bonds and FX instruments such as forwards and swaps, using a proprietary data set. In order to estimate the currency risk premium we also assess the Covered Interest rate Parity (CIP) and the Uncovered Interest rate Parity (UIP) hypotheses. We find that the CIP hypothesis did not hold during the sample period for the twelve-month horizon while the UIP hypothesis did not hold for the one-month horizon. Using various methodologies, we find that our proposed CTR measure predicted nonresident investors’ positions in FX instruments and government bonds, especially during the second sub-sample.