Carry trade

Improving FX Carry Strategy with Exotic Currencies and the Frontier Markets

31.January 2024

Forex markets lure retail traders into a game of “hunting pips” with high leverage and high turnover scalping strategies, in which small traders often lose more than they can afford. But there are other ways of trading currencies. The smart money knows how to exploit interest rate spreads that this asset class offers by employing the FX Carry Trade strategy. In the past decade, the low interest rates of the most developed countries made the FX Carry strategy less profitable, but as inflation returned, higher interest rates returned in some countries, too, and with them, the interest rate spreads widened. And FX Carry is back, and the question stands: Can we improve this well-known trading style?

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Three Simple Tactical FX Hedging Strategies

8.October 2021

There are many ways one can lose money when investing, and exchange rates are one of the potential risk factors. Luckily, there are several ways to minimize this type of loss in your portfolio. Systematic FX hedging that uses currency factor strategies is a way of protecting an existing or anticipated position from an unwanted move in an exchange rate. It does not eliminate the risk of loss completely but helps to manage currency exposure better.

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What is the Bitcoin’s Risk-Free Interest Rate?

7.February 2020

Some see Bitcoin (BTC) as a payment method of the future; others see it as a speculative asset class. Despite the speculative activity connected with Bitcoin, after all, it is a currency that is different from fiat currencies like the US Dollar or Euro. If you hold fiat currency, there is an opportunity to earn a risk-free rate. But is there the same opportunity also in Bitcoin? And what are the Bitcoin’s risk-free and market rates? These are the questions we had in Quantpedia, and we invite you to join us in our thought experiment that tries to answer them …

Authors: Vojtko, Padysak

Title: What is the Bitcoin’s Risk-Free Interest Rate?

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Impact of Currency Volatility on Momentum and Carry Factors

5.November 2019

What is the impact of volatility (and changes in volatility) on popular Currency Momentum and Currency Carry strategies? That’s the topic of recent academic study written by Duc Hong Hoang, which decomposes foreign exchange volatility into two components, namely, secular (long-term) and transitory or mean-reverting (short-term) components. Long term component captures business cycle effects, while short term volatility usually represents funding tightness or shocks. Carry trade strategy is linked (and therefore partially predictable) to long-run volatility while momentum reacts mainly to short-run risks.

Author: Hoang

Title: Long Run and Short Run Risk Premium in Currency Market

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Factor Investing in Currency Markets

26.July 2019

A new research paper related to multiple currency strategies:

#5 – FX Carry Trade
#8 – Currency Momentum Factor
#9 – Currency Value Factor – PPP Strategy

Authors: Baku, Fortes, Herve, Lezmi, Malongo, Roncalli, Xu

Title: Factor Investing in Currency Markets: Does it Make Sense?

Link: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3415700

Abstract:

The concept of factor investing emerged at the end of the 2000s and has completely changed the landscape of equity investing. Today, institutional investors structure their strategic asset allocation around five risk factors: size, value, low beta, momentum and quality. This approach has been extended to multi-asset portfolios and is known as the alternative risk premia model. This framework recognizes that the construction of diversified portfolios cannot only be reduced to the allocation policy between asset classes, such as stocks and bonds. Indeed, diversification is multifaceted and must also consider alternative risk factors. More recently, factor investing has gained popularity in the fixed income universe, even though the use of risk factors is an old topic for modeling the yield curve and pricing interest rate contingent claims. Factor investing is now implemented for managing portfolios of corporate bonds or emerging bonds.

In this paper, we focus on currency markets. The dynamics of foreign exchange rates are generally explained by several theoretical economic models that are commonly presented as competing approaches. In our opinion, they are more complementary and they can be the backbone of a Fama-French-Carhart risk factor model for currencies. In particular, we show that these risk factors
may explain a significant part of time-series and cross-section returns in foreign exchange markets. Therefore, this result helps us to better understand the management of forex portfolios. To illustrate this point, we provide some applications concerning basket hedging, overlay management and the construction of alpha strategies.

Notable quotations from the academic research paper:

"In this paper, we propose analyzing foreign exchange rates using three main risk factors: carry, value and momentum. The choice of these market risk factors is driven by the economic models of foreign exchange rates. For instance, the carry risk factor is based on the uncovered interest rate parity, the value risk factor is derived from equilibrium models of the real exchange rate, and the momentum risk factor bene fits from the importance of technical analysis, trading behavior and overreaction/underreaction patterns. Moreover, analyzing an asset using these three dimensions helps to better characterize the fi nancial patterns that impact an asset: its income, its price and its trend dynamics. Indeed, carry is associated with the yield of the asset, value measures the fair price or the fundamental risk and momentum summarizes the recent price movements.

FX Carry

FX Value

FX Momentum

By using carry, value and momentum risk factors, we are equipped to study the cross-section and time-series of currency returns. In the case of stocks and bonds, academics present their results at the portfolio level because of the large universe of these asset classes. Since the number of currencies is limited, we can show the results at the security level.

For each currency, we can then estimate the sensitivity with respect to each risk factor, the importance of common risk factors, when speci fic risk does matter, etc. We can also connect statistical figures with monetary policies and regimes, illustrating the high interconnectedness of market risk factors and economic risk factors. The primary goal of building an APT model for currencies is to have a framework for analyzing and comparing the behavior of currency returns. This is the main objective of this paper, and a more appropriate title would have been "Factor Analysis of Currency Returns". By choosing the title "Factor Investing in Currency Markets", we emphasize that our risk factor framework can also help to manage currency portfolios as security analysis always comes before investment decisions.

This paper is organized as follows. Section Two is dedicated to the economics of foreign exchange rates. We fi rst introduce the concept of real exchange rate, which is central for understanding the di fferent theories of exchange rate determination. Then, we focus on interest rate and purchasing power parities. Studying monetary models and identifying the statistical properties of currency returns also helps to defi ne the market risk factors, which are presented in Section Three. These risk factors are built using the same approach in terms of portfolio composition and rebalancing. Section Four presents the cross-section and time-series analysis of each currency. We can then estimate a time-varying APT-based model in order to understand the dynamics of currency markets. The results of this dynamic model can be used to manage a currency portfolio. This is why Section Five considers hedging and
overlay management."


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Three Insights from Academic Research Related to Carry Trade Strategy

27.March 2019

What are the main insights?

– carry trade profitbility depends on the positive order-flow of sophisticated financial customers (hedge funds and asset managers)

– carry trade strategy is profitable, but it is hard to pick correct trading rules ex-ante

– future alpha of a high interest rate currency carry portfolio increases in a trough in a business cycle and in a state of high market uncertainty

1/

Authors: Burnside, Cerrato, Zhang

Title: Foreign Exchange Order Flow as a Risk Factor

Link: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3275356

Abstract:

This paper proposes a set of novel pricing factors for currency returns that are motivated by microstructure models. In so doing, we bring two strands of the exchange rate literature, namely market-microstructure and risk-based models, closer together. Our novel factors use order flow data to provide direct measures of buying and selling pressure related to carry trading and momentum strategies. We find that they appear to be good proxies for currency crash risk. Additionally, we show that the association between our order-flow factors and currency returns differs according to the customer segment of the foreign exchange market. In particular, it appears that financial customers are risk takers in the market, while non-financial customers serve as liquidity providers.

2/

Authors: Hsu, Taylor, Wang

Title: The Profitability of Carry Trades: Reality or Illusion?

Link: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3158101

Abstract:

We carry out a large-scale investigation of the profitability of carry trades, using foreign exchange data for 48 countries spanning a period from 1983 to 2016 and employing a stepwise test to counter data-snooping bias. We find that, while we can confirm previous findings that the carry trade is profitable over this long period when a specific carry-trade strategy is selected based on the whole data set, even after controlling for data snooping, when we split the sample into sub-periods, the best carry-trade strategy in one sub-period is generally not profitable in the next sub-period. This finding holds true even when we include learning strategies and stop-loss strategies. Our findings thus highlight the instability of carry trades over long periods and their limitation in the sense that it is hard to predict their performance based on several years of data and therefore to choose a profitable carry-trade strategy ex ante.

3/

Author: Sakemoto

Title: Currency Carry Trades and the Conditional Factor Model

Link: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3210768

Abstract:

This study employs a conditional factor model in order to investigate the time-varying profitability of currency carry trades. To that end, I estimate conditional alphas and betas on the popular dollar and carry factors through the use of a nonparametric approach. The empirical results illustrate that the alphas and betas vary over time. Furthermore, I find that the alpha of a high interest rate currency portfolio increases in a trough in a business cycle and in a state of high market uncertainty. However, the beta on the dollar factor decreases in these market conditions, suggesting that investors reduce the foreign currency risk exposure.


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