Understanding the FX Carry Trade: An Empirical Study

Adam Bloch

Student thesis: Master thesis

Abstract

This paper dives in to the profitability of the currency carry trade for the G10 currencies. The paper demonstrates that the British Pound is the provides the highest excess return although mostly driven by an appreciation of the exchange rate whereas The New Zealand Dollar provides the highest interest rate differential and only experience a smaller depreciation of the exchange rate, which makes it the second most profitable strategy. In addition, finds that high interest rate currencies are exposed to crash risk, which points towards the fact that currency investors “go up by the stairs and down by the elevator”. Besides studying the currency carry trade on a stand-alone basis, the paper examines how the currency carry can provide value to a mean-variance optimizing investor. Here the paper finds that interest rates and currencies generally has low correlation with equities and bonds, making it a valuable asset for diversification. In order to derive to this result, the paper examines nine portfolios keeping three assets fixed and changing each of the currency carry strategies for each of the nine portfolios. The result is that the minimum variance portfolio with the lowest standard deviation is the Australian Dollar whereas the maximum slope portfolio with the highest risk-return trade-off is the Australian Dollar carry maximum slope portfolio. Finally, the tangency portfolio with the highest Sharpe Ratio is the Japanese Yen carry trade tangency portfolio.

EducationsMSc in Finance and Investments, (Graduate Programme) Final Thesis
LanguageEnglish
Publication date2020
Number of pages69