FX Carry Risk Mitigation Papers

Two new research papers related to a favorite anomaly of financial academics – forward premium puzzle aka. currency carry. Academic papers offer a way to increase performance (and decrease a risk) a little by employing a risk mitigation strategies:

A related papers to:

#5 – FX Carry Trade

Authors: Melvin, Shand

Title: When Carry Goes Bad: The Magnitude, Causes, and Duration of Currency Carry Unwinds

Link: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2897482

Abstract:

We analyze the worst currency carry loss episodes in recent decades, including causes, attribution by currency, timing, and the duration of carry drawdowns. To explore the determinants of the length of carry losses, a model of carry drawdown duration is estimated. We find evidence that drawdown duration varies systematically with expected return from the carry trade at the onset of the drawdown, financial stress indicators and the magnitude of deviations from a fundamental value portfolio of the carry-related portfolio holdings. In an out-of-sample test, we show that these determinants can be used to control carry-related losses and improve investment performance.

And

Authors: Lee, Wang

Title: The Impact of Jumps on Carry Trade Returns

Link: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2917694

Abstract:

This paper investigates how jump risks are priced in currency markets. We find that currencies whose changes are more sensitive to negative market jumps provide significantly higher expected returns. The positive risk premium constitutes compensation for the extreme losses during periods of market turmoil. Using the empirical findings, we propose a jump modified carry trade strategy, which has approximately 2-percentage-point (per annum) higher returns than the regular carry trade strategy. These findings result from the fact that negative jump betas are significantly related to the riskiness of currencies and business conditions.

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