Dollar Carry Trade

A conventional carry trade strategy (systematically selling low-yield currencies against high-yield currencies) is probably the most widely known strategy in the currency market. Recent academic research shows that currency yield (calculated via a forward discount/premium) is useful not only for a cross-sectional analysis but also for individual currencies. The research paper shows how it is easily possible to time the US dollar against a basket of currencies based on the average forward premium difference. This strategy is called the dollar carry trade, and it is very loosely correlated with conventional carry trade returns. Therefore, this strategy makes a nice add-on to other FX strategies.

Fundamental reason

Academic research shows that the dollar carry trade captures the US-specific compensation for bearing US as well as global risk, while the global carry trade captures the compensation for global risk exposure, which is common to all countries. The average forward discount of the dollar against a basket of developed country currencies is a strong predictor of excess returns. U.S. investors expect to be compensated more for bearing that risk during recessions when U.S. interest rates are low. This risk premium could be called the dollar risk premium. By implementing the dollar carry trade, he pockets this dollar risk premium when the U.S. risk price is high.

Markets traded
currencies
Confidence in anomaly's validity
Strong
Notes to Confidence in anomaly's validity
Period of rebalancing
Monthly
Notes to Period of rebalancing
Number of traded instruments
10
Notes to Number of traded instruments
it depends on investor's need for diversification (10-20)
Complexity evaluation
Simple strategy
Notes to Complexity evaluation
Financial instruments
futures, forwards, swaps, CFDs
Backtest period from source paper
1983-2009
Indicative performance
5.60%
Notes to Indicative performance
per annum, data from table 1 Panel A, return could be easily leveraged and strategy could deliver higher returns and match a risk with a traditional carry trade strategy or an equity market
Estimated volatility
8.53%
Notes to Estimated volatility
per annum, data from table 1 Panel A
Maximum drawdown
not stated
Notes to Maximum drawdown
Sharpe Ratio
0.66

Keywords:

carry trade, FX anomaly, forex system

Simple trading strategy

The investment universe consists of currencies from developed countries (the Euro area, Australia, Canada, Denmark, Japan, New Zealand, Norway, Sweden, Switzerland, and the United Kingdom). The average forward discount (AFD) is calculated for this basket of currencies (each currency has an equal weight). The average 3-month rate could be used instead of the AFD in the calculation. The AFD is then compared to the 3-month US Treasury rate. The investor goes long on the US dollar and short on the basket of currencies if the 3-month US Treasury rate is higher than the AFD. The investor goes short on the US dollar and long on the basket of currencies if the 3-month US Treasury rate is higher than the AFD. The portfolio is rebalanced monthly.

Hedge for stocks during bear markets

Not known - Source and related research papers don't offer insight into correlation structure of trading strategy to equity market risk, therefore we do not know if this strategy can be used as a hedge/diversification during time of market crisis. Currency strategies often have a negative correlation to equities therefore proposed strategy can be negatively correlated too, but rigorous backtest is needed to asses if this is the case ...

Source Paper

Lustig, Roussanov, Verdelhan: Countercyclical Currency Risk Premia and the Dollar Carry Trade
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1541230
Abstract:
The dollar carry trade goes long a basket of foreign currencies and short the dollar when the average forward discount for the basket is positive and takes the opposite position when the average forward discount is negative. The returns on the dollar carry trade are uncorrelated with the returns on the high-minus-low global currency carry trade, which is dollar neutral, but the dollar carry trade offers even higher Sharpe ratios. Using a no-arbitrage model of exchange rates, we show that these excess returns compensate U.S. investors for taking on U.S. speciffc risk by shorting the dollar in U.S. recessions, and for taking on global risk by going long in the dollar in bad times. The model implies that countries whose exposures to global shocks differ substantially from the average exhibit much less currency return predictability, a prediction that we show is borne out by the data.

Other Papers

Hassan, Mano: Forward and Spot Exchange Rates in a Multi-Currency World
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2272893
Abstract:
We decompose the covariance of currency returns with forward premia into a cross-currency, a between-time-and-currency, and a cross-time component. The surprising result of our decomposition is that the cross-currency and cross-time-components account for almost all systematic variation in expected currency returns, while the between-time-and-currency component is statistically and economically insignificant. This finding has three surprising implications for models of currency risk premia. First, it shows that the two most famous anomalies in international currency markets, the carry trade and the Forward Premium Puzzle (FPP), are separate phenomena that may require separate explanations. The carry trade is driven by persistent differences in currency risk premia across countries, while the FPP appears to be driven primarily by time-series variation in all currency risk premia against the US dollar. Second, it shows that both the carry trade and the FPP are puzzles about asymmetries in the risk characteristics of countries. The carry trade results from persistent differences in the risk characteristics of individual countries; the FPP is best explained by time variation in the average return of all currencies against the US dollar. As a result, existing models in which two symmetric countries interact in financial markets cannot explain either of the two anomalies.

Jurek, Xu: Option-Implied Currency Risk Premia
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2338585
Abstract:
We use cross-sectional information on the prices of G10 currency options to calibrate a non-Gaussian model of pricing kernel dynamics and construct estimates of conditional currency risk premia. We find that the mean historical returns to short dollar and carry factors (HML-FX) are statistically indistinguishable from their option-implied counterparts, which are free from peso problems. Skewness and higher-order moments of the pricing kernel innovations on average account for only 15% of the HML-FX risk premium in G10 currencies. These results are consistent with the observation that crash-hedged currency carry trades continue to deliver positive excess returns.

Shehadeh, Erdos, Li, Moore: US Dollar Carry Trades in the Era of 'Cheap Money'
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2765552
Abstract:
In this paper, we employ a unique dataset of actual US dollar (USD) forward positions against a number of currencies taken by so-called Commodity Trading Advisors (CTAs). We investigate to what extent these positions exhibit a pattern of USD carry trading or other patterns of currency trading over the recent period of the ultra-loose US monetary policy. Our analysis indeed shows that USD positions against emerging market currencies are characterised by a pattern of carry trading. That is, the USD, as the lower yielding currency, is associated with short positions. The payoff distributions of these positions, moreover, are found to have positive Sharpe ratios, negative skewness and high kurtosis. On the other hand, we find that USD positions against other advanced country currencies have a pattern completely opposite to carry trading which is in line with uncovered interest parity trading; that is, the lower (higher) yielding currency is associated with long (short) positions.

Jiang: US Fiscal Cycle and the Dollar
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3278339
Abstract:
When the US fiscal condition is strong, the dollar is strong and continues to appreciate against foreign currencies in the next 3 years. This pattern is unique to the US, explaining 50% of the low-frequency variation in the dollar's value and absorbing the return predictability of the forward premium. In a model with sticky prices, I show this pattern is driven by the comovement between the US fiscal cycle and the US investors' risk appetite: During US expansions, higher US government surpluses increase the nominal value of the dollar, while less risk-averse US investors require lower returns to hold foreign currencies. Consistent with this view, the US fiscal cycle also explains the term premium, the dollar carry trade, the currency return momentum, and the US investors' capital flows.

Opie, Riddiough: Global Currency Hedging with Common Risk Factors
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3264531
Abstract:
We propose a novel method for dynamically hedging foreign exchange exposure in international equity and bond portfolios. The method exploits time-series predictability in currency returns that we find emerges from a forecastable component in currency factor returns. The hedging strategy outperforms leading alternative approaches out-of-sample across a large set of performance metrics. Moreover, we find that exploiting the predictability of currency returns via an independent currency portfolio delivers a high risk-adjusted return and provides superior diversification gains to global equity and bond investors relative to currency carry, value, and momentum investment strategies.

Hypothetical future performance