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Carry Trade and Systemic Risk: Why are FX Options So Cheap?

Last Updated on 10 February, 2024 by Rejaul Karim

The research paper “Carry Trade and Systemic Risk: Why are FX Options So Cheap?” investigates the intriguing discrepancy between the perceived excess returns of popular carry trade strategies and their actual systemic-risk-adjusted returns.

The study reveals a notable correlation between carry trade returns and the returns of a VIX rolldown strategy, underlining the prowess of shorting VIX futures and rolling down its term structure as an alternative strategy. Remarkably, hedging the carry with exchange rate options yields substantial returns that are not necessarily a compensation for systemic risk.

The paper delves into the underlying reason for this phenomenon, attributing it to the exchange rate options providing a cost-effective avenue for systemic insurance.

This nuanced analysis offers valuable insights into carry trade dynamics, the efficacy of alternative strategies, and the intricate relationship between systemic risk and currency markets, thereby contributing to our comprehension of these critical facets of financial economics.

Abstract Of Paper

In this paper we document first that, in contrast with their widely perceived excess returns, popular carry trade strategies yield low systemic-risk-adjusted returns. In particular, we show that carry trade returns are highly correlated with the return of a VIX rolldown strategy — i.e., the strategy of shorting VIX futures and rolling down its term structure — and that the latter strategy performs at least as well as betaadjusted carry trades, for individual currencies and diversified portfolios. In contrast, hedging the carry with exchange rate options produces large returns that are not a compensation for systemic risk. We show that this result stems from the fact that the corresponding portfolio of exchange rate options provides a cheap form of systemic insurance.

Original paper – Download PDF

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Author

Ricardo J. Caballero
Massachusetts Institute of Technology (MIT) – Department of Economics; National Bureau of Economic Research (NBER)

Joseph B. Doyle
Cornerstone Research, Inc.

Conclusion

In conclusion, “Carry Trade and Systemic Risk: Why are FX Options So Cheap?” sheds light on the intriguing discrepancy between perceived excess returns and actual systemic-risk-adjusted returns in popular carry trade strategies.

The study highlights a strong correlation between carry trade returns and the returns of a VIX rolldown strategy, demonstrating the competitive performance of the latter as compared to beta-adjusted carry trades across individual currencies and diversified portfolios.

Notably, the hedging of carry trades with exchange rate options yields substantial returns that are not necessarily a compensation for systemic risk, attributing this result to the cost-effectiveness of the corresponding portfolio of exchange rate options in providing systemic insurance.

These insights enrich our understanding of the intricate dynamics of carry trade strategies, alternative risk management tools, and the interplay between systemic risk and financial markets, contributing significantly to the discourse on risk-adjusted returns and investment strategies within the realm of currency markets.

Related Reading:

FX Liquidity Risk and Carry Trade Returns

Currency Premia and Global Imbalances

FAQ

Q1: What does the research paper “Carry Trade and Systemic Risk: Why are FX Options So Cheap?” investigate regarding popular carry trade strategies?

A1: The research paper investigates the perceived excess returns of popular carry trade strategies and their actual systemic-risk-adjusted returns. It highlights that, contrary to widely perceived excess returns, popular carry trade strategies yield low systemic-risk-adjusted returns.

Q2: What is the correlation discussed in the paper regarding carry trade returns and the returns of a VIX rolldown strategy?

A2: The paper reveals a notable correlation between carry trade returns and the returns of a VIX rolldown strategy. The VIX rolldown strategy involves shorting VIX futures and rolling down its term structure. The study indicates that this strategy performs at least as well as beta-adjusted carry trades, both for individual currencies and diversified portfolios.

Q3: Why do exchange rate options play a significant role in the results discussed in the paper?

A3: Exchange rate options play a significant role in the results because hedging carry trades with exchange rate options yields substantial returns that are not necessarily a compensation for systemic risk. The paper attributes this result to the fact that the corresponding portfolio of exchange rate options provides a cost-effective form of systemic insurance. Exchange rate options serve as a cheap avenue for systemic risk management in the context of carry trade strategies.

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