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Beyond the Carry Trade: Optimal Currency Portfolios Explained

Last Updated on 10 February, 2024 by Rejaul Karim

The research paper “Beyond the Carry Trade: Optimal Currency Portfolios,” offers a compelling exploration into the relevance of technical and fundamental variables in shaping currency portfolios. This multifaceted study delves into the contributions of carry, momentum, and reversal, showcasing their impact on portfolio performance.

Notably, the resulting optimal portfolio transcends the limitations of the carry trade and other conventional benchmarks, demonstrating its prowess through an extensive 16-year out-of-sample test. Its risk-adjusted returns emerge as a valuable asset for diversified investors, accentuating the potential to augment the Sharpe ratio of diversified portfolios and mitigate crash risk.

The anomaly of currency returns is astutely discussed, offering a thought-provoking narrative that hints at a gradual correction as hedge fund capital continues to influence the landscape. This paper embodies a captivating exploration of the forward rate premium, carry trade, currency market, and the intriguing concept of optimal portfolios.

Abstract Of Paper

We test the relevance of technical and fundamental variables in forming currency portfolios. Carry, momentum and reversal all contribute to portfolio performance, whereas the real exchange rate and the current account do not. The resulting optimal portfolio outperforms the carry trade and other naive benchmarks in an extensive 16 year out-of-sample test. Its returns are not explained by risk and are valuable to diversified investors holding stocks and bonds. Exposure to currencies increases the Sharpe ratio of diversified portfolios by 0.5 on average, while reducing crash risk. We argue that currency returns are an anomaly which is gradually being corrected as hedge fund capital increases.

Original paper – Download PDF

Here you can download the PDF and original paper of Beyond the Carry Trade: Optimal Currency Portfolios.

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Author

Pedro Barroso
CATÓLICA-LISBON School of Business & Economics

Pedro Santa-Clara
Nova School of Business and Economics; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Conclusion

Conclusively, the study “Beyond the Carry Trade: Optimal Currency Portfolios” presents a groundbreaking revelation of the nuanced dynamics shaping currency portfolios, challenging conventional wisdom through profound empirical evidence.

The amalgamation of carry, momentum, and reversal in portfolio construction manifests as a catalyst for enhanced performance, eclipsing the limitations of traditional benchmarks in a rigorous 16-year out-of-sample test.

Notably, the risk-adjusted returns of the optimal portfolio stand out as an invaluable asset for a diverse cohort of investors, offering an uptick in the Sharpe ratio for diversified portfolios while concurrently curbing crash risk.

This research enigmaticizes the anomaly of currency returns, suggesting a gradual recalibration as the influence of hedge fund capital continues to permeate the market. With its discourse on forward rate premium, the carry trade, and optimal portfolio strategies, this study stands as a beacon of enlightenment within the currency market domain.

Related Reading:

A Low-Risk Strategy Based on Higher Moments in Currency Markets

Economic Momentum and Currency Returns

FAQ

A3: The study suggests that currency returns represent an anomaly that is gradually being corrected as hedge fund capital increases. The narrative hints at a recalibration of currency returns in the evolving landscape, offering insights into the market dynamics influenced by hedge fund capital.

You can find many more Research Papers here

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