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The Carry Trade: Risks and Drawdowns

Last Updated on 10 February, 2024 by Rejaul Karim

The research paper “The Carry Trade: Risks and Drawdowns,” authored by Kent D. Daniel, Robert J. Hodrick, and Zhongjin Lu delves into the critical analysis of dollar-based and dollar-neutral G10 carry trades.

Highlighting significant differences between the two, the paper uncovers that dollar-neutral trades demonstrate positive average returns and high negative skewness, amidst correlations with risk factors and substantial downside risk.

Contrarily, a diversified dollar-carry portfolio features a higher average excess return, an increased Sharpe ratio, minimal skewness, and no downside risk, while remaining uncorrelated with standard risk-factors.

The distributions of drawdowns and maximum losses from daily data underscore the impact of time-varying autocorrelation on negative skewness at longer horizons in the domain of the currency carry trade.

Abstract Of Paper

We find important differences in dollar-based and dollar-neutral G10 carry trades. Dollar-neutral trades have positive average returns, are highly negatively skewed, are correlated with risk factors, and exhibit considerable downside risk. In contrast, a diversified dollar-carry portfolio has a higher average excess return, a higher Sharpe ratio, minimal skewness, is uncorrelated with standard risk-factors, and exhibits no downside risk. Distributions of drawdowns and maximum losses from daily data indicate a role for time-varying autocorrelation in determining negative skewness at longer horizons.

Original paper – Download PDF

Here you can download the PDF and original paper of The Carry Trade: Risks and Drawdowns.

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Author

Kent D. Daniel
Columbia University – Columbia Business School, Finance; National Bureau of Economic Research (NBER)

Robert J. Hodrick
Columbia University – Columbia Business School, Finance; National Bureau of Economic Research (NBER)

Zhongjin Lu
University of Georgia – Department of Finance

Conclusion

The revelations presented in the research paper significantly contribute to our understanding of the complexities inherent in the currency carry trade, especially in the context of dollar-based versus dollar-neutral G10 carry trades.

The contrasting characteristics of these trades underscore nuanced risk and return dynamics, shedding light on the impact of time-varying autocorrelation on negative skewness at longer horizons.

The findings provoke a reassessment of market efficiency and the interplay between risk factors and carry trades, offering valuable insights that have implications for market participants and risk management practices within the currency market.

Related Reading:

The Term Structure of Currency Carry Trade Risk Premia

Carry Trades and Tail Risk of Exchange Rates

FAQ

Q1: What are the key differences between dollar-based and dollar-neutral G10 carry trades, as highlighted in the research paper “The Carry Trade: Risks and Drawdowns”?

A1: The research paper identifies important differences between dollar-based and dollar-neutral G10 carry trades. Dollar-neutral trades are characterized by positive average returns, high negative skewness, correlations with risk factors, and substantial downside risk. On the other hand, a diversified dollar-carry portfolio exhibits a higher average excess return, a higher Sharpe ratio, minimal skewness, is uncorrelated with standard risk factors, and shows no downside risk.

Q2: What are the characteristics of dollar-neutral trades and a diversified dollar-carry portfolio in terms of average returns, skewness, and correlation with risk factors?

A2: Dollar-neutral trades have positive average returns, high negative skewness, and correlations with risk factors, but they also demonstrate considerable downside risk. In contrast, a diversified dollar-carry portfolio features a higher average excess return, a higher Sharpe ratio, minimal skewness, is uncorrelated with standard risk factors, and exhibits no downside risk.

Q3: How do the distributions of drawdowns and maximum losses from daily data contribute to the understanding of negative skewness in the currency carry trade?

A3: The distributions of drawdowns and maximum losses from daily data indicate a role for time-varying autocorrelation in determining negative skewness at longer horizons in the currency carry trade. This suggests that the impact of time-varying autocorrelation is a factor influencing the negative skewness observed in the longer-term performance of carry trades.

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