New strategies:
#221 –Timing Carry Trade v2
Period of rebalancing: Monthly
Markets traded: currencies
Instruments used for trading: futures, forwards, swaps, CFDs
Complexity: Moderately complex strategy
Bactest period: 1985 – 2011
Indicative performance: 9.16%
Estimated volatility: 9.07%
Source paper:
Hu, Jacobsen: Predictability in the Short and Long Legs of Carry Trades
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2166604
Abstract:
Payoffs from both the short and long legs of dynamic carry trades are predictable. The world equity index return positively predicts short leg payoffs, while changes in the commodity index positively predict long leg payoffs. Changes in currency volatility and changes in equity volatility negatively predict the payoff from each leg of carry trades. Time-varying risk premia do not seem to explain this predictability. The evidence in this paper points towards gradual information diffusion as the most likely explanation.
New research papers related to existing strategy:
#184 – Timing Carry Trade
Clarida, Davis, Pedersen: CURRENCY CARRY TRADE REGIMES: BEYOND THE FAMA REGRESSION
http://www.nber.org/papers/w15523.pdf
Abstract:
We examine the factors that account for the returns on currency carry trade strategies. Using a dataset of daily returns spanning 18 years for 5 different long – short currency carry portfolios, we first document a robust empirical relationship between carry trade excess returns and exchange rate volatility, both realized and implied. Specifically, we extend and refine the results in Bhansali (2007) by documenting that currency carry trade strategies implemented with forward contracts have payoff and risk characteristics that are similar to those of currency option strategies that sell out of the money puts on high interest rates currencies. Both strategies have the feature of collecting premiums or carry to generate persistent excess returns that unwind sharply resulting in losses when actual and implied volatility rise.
Caglayan, Pinter: Development and Calibration of Currency Market Strategies by Global Optimization
http://www.optimization-online.org/DB_FILE/2010/06/2658.pdf
Abstract:
We have developed a new financial indicator – called the Interest Rate Differential Adjusted for Volatility (IRDAV) measure – to assist investors in currency markets. On a monthly basis, we rank currency pairs according to this measure and generate a basket of pairs with the highest IRDAV values. Under positive market conditions, an IRDAV based investment strategy (buying a currency with high interest rate and simultaneously selling a currency with low interest rate, after adjusting for volatility of the currency pairs in question) can generate significant returns. However, whenever the markets turn for the worse and crisis situations evolve, investors exit such money making strategies suddenly, and – as a result – significant losses can occur. In an effort to minimize these potential losses, our research work generates an aggregate risk metric that evaluates (estimates) the total risk by looking at various indicators across different markets. These risk indicators are used to get timely signals of evolving crises and to flip the strategy from long to short in a timely fashion, to prevent losses and make further gains even during crisis periods. Since our model is implemented in Excel as a highly nonlinear computational procedure, we utilize global optimization software (Excel-LGO) to maximize the performance of the currency basket, based on our selection of key decision variables. We introduce the new currency trading model and its implementation, and then present numerical results based on actual market data.
