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From Carry Trades to Curvy Trades

Last Updated on 10 February, 2024 by Rejaul Karim

The research paper “From Carry Trades to Curvy Trades” authored by Ferdinand Dreher, Johannes Gräb, and Thomas Kostka broaches the evolution of traditional carry trade strategies that hinge solely on disparities in short-term interest rates without factoring in additional pertinent information encapsulated within yield curves.

This scholarly study meticulously scrutinizes the return distributions of carry trade portfolios encompassing G10 currencies and espouses a novel approach wherein the signals to procure and vend currencies pivot on comprehensive measures of the yield curve, namely the Nelson-Siegel factors.

The crux of the study revolves around the revelation that a strategy anchored in the relative curvature factor – the curvy trade – begets higher Sharpe ratios and evinces diminished return skewness relative to conventional carry trade strategies.

Astonishingly, curvy trades embody lesser reliance on typical carry currencies, such as the Japanese yen and the Swiss franc, thereby impeding vulnerability to crash risk. The standard pricing factors of traditional carry trade returns prove futile in explicating curvy trade returns within a linear asset pricing framework, as indicated by this study.

Abstract Of Paper

Traditional carry trade strategies are based on differences in short-term interest rates, neglecting any other information embedded in yield curves. We derive return distributions of carry trade portfolios among G10 currencies, where the signals to buy and sell currencies are based on summary measures of the yield curve, the Nelson-Siegel factors. We nd that a strategy based on the relative curvature factor, the curvy trade, yields higher Sharpe ratios and a smaller return skewness than traditional carry trade strategies. Curvy trades build less upon the typical carry currencies, like the Japanese yen and the Swiss franc, and are hence less susceptible to crash risk. In line with that, standard pricing factors of traditional carry trade returns, such as exchange rate volatility, fail to explain curvy trade returns in a linear asset pricing framework. Our findings are in line with recent interpretations of the curvature factor. A relatively high curvature signals a relatively higher path of future short-term rates over the medium-term putting upward pressure on the currency.

Original paper – Download PDF

Here you can download the PDF and original paper of From Carry Trades to Curvy Trades.

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Author

Ferdinand Dreher
University of Groningen

Johannes Gräb
European Central Bank (ECB)

Thomas Kostka
European Central Bank (ECB)

Conclusion

In denouement, the research paper “From Carry Trades to Curvy Trades” penned by Ferdinand Dreher, Johannes Gräb, and Thomas Kostka engenders a paradigm shift in the realm of currency trading strategies, transcending the rudimentary construct of traditional carry trade strategies by leveraging yield curves to engender curvy trades.

This study aptly demonstrates that curvy trades, predicated on the relative curvature factor, equip investors with higher Sharpe ratios and mitigate return skewness relative to conventional carry trade strategies.

Notably, curvy trades exhibit a reduced reliance on customary carry currencies, thus mitigating vulnerability to crash risk. Moreover, standard pricing factors that underpin traditional carry trade returns are ineffectual in accounting for the nuanced dynamics underpinning curvy trade returns.

The paper, buoyed by these compelling findings, lends credence to recent interpretations of the curvature factor, underscoring its pivotal role in exerting an upward pressure on the currency vis-à-vis the relatively higher path of future short-term rates inherent in the medium-term.

Related Reading:

Currency Returns in Different Time Zones

Momentum and Trend Following Trading Strategies for Currencies Revisited – Combining Academia and Industry

FAQ

Q1: What is the focus of the research paper “From Carry Trades to Curvy Trades”?

A1: The research paper focuses on the evolution of traditional carry trade strategies, which are based solely on differences in short-term interest rates, to a novel approach called “curvy trades.” Curvy trades incorporate additional information from yield curves, specifically the Nelson-Siegel factors, to make currency trading decisions.

Q2: How does the curvy trade strategy differ from traditional carry trade strategies?

A2: The curvy trade strategy differs from traditional carry trade strategies by using the relative curvature factor derived from yield curves, specifically the Nelson-Siegel factors. The study shows that the curvy trade strategy yields higher Sharpe ratios, reduced return skewness, and a diminished reliance on typical carry currencies, such as the Japanese yen and the Swiss franc.

Q3: What are the key findings of the study regarding curvy trades?

A3: The study finds that the curvy trade strategy, based on the relative curvature factor, produces higher Sharpe ratios and lower return skewness compared to traditional carry trade strategies. Curvy trades also exhibit reduced dependence on typical carry currencies, making them less susceptible to crash risk. Additionally, standard pricing factors that explain traditional carry trade returns are ineffective in explaining curvy trade returns within a linear asset pricing framework.

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