Many recent papers have investigated the role played by volatility in determining the cross-section of currency returns … returns from the currency carry trade. We show that the importance of volatility depends on whether the currency markets are … unexpectedly volatile. Volatility innovations during relatively tranquil periods are largely unrewarded in the market, whereas …

more often tend to appreciate rather than depreciate, as noted by Fama (1983). In this paper, we treat volatility as the … critical state variable and show that positive returns to the carry trade are overwhelmingly generated in the low-volatility … "normal" state, whereas the high-volatility state is associated with lower returns or with losses as currencies revert to the …