Optimally Diversified Currency Carry Trade

Posted in Currency Trading, Strategic Allocation


Does mean-variance optimization enhance the performance of currency carry trades (long currencies with high interest rates and short currencies with low interest rates)? In their November 2012 paper entitled “On the Risk and Return of the Carry Trade”, Fabian Ackermann, Walt Pohl and Karl Schmedders compare a dynamic mean-variance optimal carry trade strategy to naive ones. Specifically, they consider a series of monthly investments that are long (short) those of the following currencies with the highest (lowest) associated interest rates: U.S. dollar (base currency),¬†Swiss franc, Euro, Japanese yen, British pound, Australian dollar, Canadian dollar, Norwegian krone, Swedish krona, Singapore dollar and New Zealand dollar. For monthly mean-variance optimization, they estimate currency correlations based on the last 250 days (one year) of daily data and set an annual excess return target¬†of 5% (relative to the risk-free rate), the approximate excess return on the S&P 500 Index over the same period. For naive portfolios, they consider 1 long/1 short currencies, 3 long/3 short equally weighted currencies and the S&P 500 Index total return. Using daily currency values and monthly S&P 500 Index data during January 1989 through June 2012 (using the first year for initial optimization), they find that: (more…)

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