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Using Option-Implied Information to Improve Currency Carry Trade Profits

Last Updated on 10 February, 2024 by Rejaul Karim

The study “Using Option-Implied Information to Improve Currency Carry Trade Profits” delves into a pioneering investigation of a parametric portfolio policy model aimed at refining the return distribution within the realm of the renowned currency carry trade investment strategy.

Authored by Michael Broll, this study confronts the dual challenge of capitalizing on the elevated returns associated with the carry trade strategy while mitigating the substantial crash risk that came to the fore during the US subprime crisis of 2008/2009.

By harnessing the power of global FX option-implied variance risk, consumer price inflation, and commodity prices as underlying risk factors, the constructed model engenders a paradigm shift, bestowing out-of-sample results marked by annualized mean returns of up to 8.4% over an eight-year period.

The compelling synthesis of low standard deviation, positively skewed returns, and the attainment of Sharpe ratios around unity, even when factoring in transaction costs, reflects the transformative potential of this model within the context of currency portfolios. With its discourse on portfolio policy, carry trade, implied variance, and crash risk, this study charts a course toward revolutionizing currency trade strategies.

Abstract Of Paper

This study investigates an efficient parametric portfolio policy model to improve the return distribution of the well-known currency carry trade investment strategy. This carry trade strategy invests into high-yielding currencies that are subsequently funded by low-yielding currencies. Following this investment procedure has led to significantly excess returns for the investors, at least over the past four decades. However, these returns were subject to a high crash risk, which hit its peak during the US subprime crisis in 2008/2009 with portfolio losses of up to one third of the investment value. The constructed model overcomes these bad portfolio properties through computing the optimal carry trade portfolio weight for any monthly revolving investment period. This is done by modeling the optimal weight as a function of the carry trade’s risk characteristics. Especially, when using global FX option-implied variance risk, as well as global consumer price inflation and commodity prices as background risk factors, the model delivers extremely-efficient out-of-sample results with annualized mean returns of up to 8.4% over an eight-year period, accompanied with a low standard deviation, positively skewed returns and leading to Sharpe ratios around unity, including transaction costs. These promising statistics are largely maintained when allowing for higher leveraged portfolios.

Original paper – Download PDF

Here you can download the PDF and original paper of Using Option-Implied Information to Improve Currency Carry Trade Profits.

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Author

Michael Broll
University of Duisburg-Essen – Department of Economics and Business Administration

Conclusion

In conclusion, the study on “Using Option-Implied Information to Improve Currency Carry Trade Profits” unfurls an innovative approach to elevating the return distribution within the domain of the well-established currency carry trade investment strategy.

Spearheaded by Michael Broll, this research delves into a breakthrough parametric portfolio policy model that effectively navigates the rocky terrain of excess returns and crash risk inherent in this investment strategy.

By leveraging global FX option-implied variance risk, consumer price inflation, and commodity prices as paramount risk factors, the model garners out-of-sample results with annualized mean returns of up to 8.4% over an eight-year period, accompanied by a low standard deviation and persistently positively skewed returns.

The attainment of Sharpe ratios hovering around unity, inclusive of transaction costs, signals the transformative potential of this model in sculpting the landscape of currency portfolios. With its focus on portfolio policy, carry trade, implied variance, and crash risk, this study culminates in redefining the contours of currency trade strategies.

Related Reading:

Optimal and Naive Diversification in Currency Markets

Importance of Transaction Costs for Asset Allocations in FX Markets

FAQ

Q1: What is the primary challenge addressed by the study “Using Option-Implied Information to Improve Currency Carry Trade Profits”?

A1: The primary challenge addressed by the study is the substantial crash risk associated with the renowned currency carry trade investment strategy. The study aims to refine the return distribution of the carry trade strategy, which involves investing in high-yielding currencies funded by low-yielding currencies. The crash risk, particularly highlighted during the US subprime crisis in 2008/2009, necessitates the development of a model that can enhance the efficiency and risk characteristics of the carry trade portfolio.

Q2: How does the parametric portfolio policy model contribute to improving the return distribution of the currency carry trade strategy?

A2: The parametric portfolio policy model contributes to improving the return distribution of the currency carry trade strategy by computing the optimal carry trade portfolio weight for any monthly revolving investment period. The model is designed to address the crash risk inherent in the strategy by incorporating risk characteristics. It leverages global FX option-implied variance risk, consumer price inflation, and commodity prices as underlying risk factors. By optimizing the portfolio weight based on these risk factors, the model aims to generate more efficient and favorable out-of-sample results in terms of annualized mean returns, standard deviation, and skewness.

Q3: What are the key findings of the study regarding the performance of the model in out-of-sample results?

A3: The study’s key findings indicate that the constructed parametric portfolio policy model, incorporating global FX option-implied variance risk, consumer price inflation, and commodity prices, delivers extremely efficient out-of-sample results. The model achieves annualized mean returns of up to 8.4% over an eight-year period. These results are accompanied by a low standard deviation, positively skewed returns, and Sharpe ratios around unity, even when accounting for transaction costs. The promising statistics hold, to a large extent, even when allowing for higher leveraged portfolios.

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