Crash-neutral currency carry trades

TLDR: In this paper, the authors compute returns to crash-hedged portfolios and demonstrate that the high returns to carry trades are not due to peso problems, but due to violations of uncovered interest rate parity in G10 currencies.

About: This article is published in Journal of Financial Economics.The article was published on 2014-09-01 and is currently open access. It has received 130 citations till now. The article focuses on the topics: Interest rate parity & Carry (investment).

Figures

Table II Relation to Equity Market Factors

Table III Returns to Crash-Neutral Currency Carry Trade Portfolios in G10 Currencies

Figure 3. Implied Volatility Functions for X/USD G10 Pairs. The figure illustrates the average implied volatility functions for foreign exchange options on nine G10 currencies versus the U.S. dollar. The implied volatilities have been scaled by the contemporaneous at-the-money implied volatilities to provide a scale-free representation of the skew. The implied volatilities at the five standardized value (10δ put, 25δ put, ATM, 25δ call, 10δ call) are actual observed quotes, and are marked with stars. All other volatilities were obtained by interpolating the data using the vanna-volga method. The dashed red (solid blue) lines correspond to time series means for periods in which the foreign one-month LIBOR rate was at least 1% above (below) the one-month U.S. dollar LIBOR rate. The underlying data are daily and cover the period from January 1999 to June 2012 (N = 3520 days).

Figure 4. Total Returns to Hedged G10 Currency Carry Trades. This figure plots the total accumulated wealth from investing in the spread-weighted, non-dollar neutral currency carry trade portfolio, under various FX option hedging schemes (top panel). Each of the option hedging schemes utilizes 10δ (out-of-the-money) FX options. Portfolios are rebalanced monthly, and returns are computed for the period from January 1999 to June 2012 (N = 162 months). The bottom panel plots the ratio of the hedged wealth to the unhedged wealth under the three hedging schemes over the same time period.

Table VI Returns to the Crash-Neutral Currency Carry Trade Portfolios in G10 Currencies: Fixed moneyness hedging

Table V Returns to Crash-Neutral Currency Carry Trade Portfolios in G10 Currencies: Inclusion of transaction costs

Frequently asked questions

Q1. What are the contributions mentioned in the paper "Crash-neutral currency carry trades" ?

At the time of publication, author [ AUTHOR NAME ] was affiliated with [ INSTITUTION NAME ]. This journal article is available at ScholarlyCommons: https: //repository. 

Q2. What is the cost of focusing on riskneutral moments?

The cost of focusing on riskneutral moments is that it requires data augmentation – interpolating the implied volatilities between the observed quotes, and extrapolating the implied volatilities outside of the observed quotes. 

Q3. What is the basic unit of observation in the analysis of returns of these strategies?

The basic unit of observation in the analysis of returns of these strategies is a currency pair excess return, which captures the net return to a zero-investment portfolio which borrows one unit of currency i, at interest rate yit,t+τ , to lend at short-term rate yjt,t+τ in market j. 

Q4. What is the virtue of the non-dollar-neutral carry trade portfolios?

The virtue of the non-dollar-neutral carry trade portfolios is that their composition is independent of the home currency of the investor. 

Q5. What is the procedure used to compute the implied volatility curve?

The authorinterpolate the implied volatility curve on each day for each currency pair using the vanna-volga scheme (Castagna and Mercurio (2007)), and conservatively append flat tails to the implied volatility curve beyond the last observed strike point (10δ). 

Q6. What is the effect of the negative exposure to the equity market?

The positive exposure to the equity market downside risk suggests that extreme negative shocks to the currency carry trade are likely to coincide with large equity market declines (and increased volatility) and therefore adverse shocks to marginal utility. 

Q7. What is the mean return of the spread-weighted portfolio?

The mean return over the full sample is 5.21% (t-stat: 2.62) for the spread-weighted portfolio and 3.36% (t-stat: 2.39) for the equal-weighted portfolio, and – in both cases – is essentially entirely accounted for by the interest rate carry component of the currency excess return. 

Q8. What is the significance of the skewness of the implied volatility curve?

The modest magnitudes of the option-implied skewness in part reflect the conservative nature of the extrapolation scheme, which appends flat tails to the implied volatility curve beyond the 10δ strike.