A treatise on currency risk and portfolio strategies
The carry trade is a zero net investment strategy that borrows in low yielding currencies and subsequently invests in high yielding currencies. It has been identified as highly profitable FX strategy delivering significantly excess returns with high Sharpe ratios. This work shows that these excess returns are compensation for bearing FX variance and crash risk. Additionally, factor risks that affect foreign money changes, foreign inflation changes, as well as changes to a newly developed Carry Trade Activity Index and the VIX index, as a proxy for global risk aversion, make up the carry trade risk anatomy. Furthermore, this study investigates an efficient parametric portfolio policy model to improve the return distribution of the currency carry trade investment strategy. 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% from 2007 to 2015, accompanied with a low standard deviation, positively skewed returns and leading to Sharpe ratios around unity, including transaction costs. The last part examines the relationship between currency option’s implied skewness and its future realized skewness, where the difference is known as the skewness risk premium (SRP). The SRP indicates whether investors pay a premium to be insured against future crash risk. Past investigations about implied and realized skewness within currency markets showed that both measures are loosely connected or even exhibit a negative relationship that cannot be rationalized by no-arbitrage arguments. It will be shown that this phenomenon can be explained in terms of investor’s position-induced demand pressure and FX momentum effects. In order to exploit the disconnection of skewness, a simple skew swap trading strategy proposed by Schneider and Trojani (2015) have been set up. The resulting skew swap returns are relatively high, but the return distribution is extremely fat-tailed. To appropriately compare different skew swap strategy returns, this paper proposes a Higher Moment Sharpe Ratio that also takes higher moments into account.