Currency Exchange Rate Options Cheap?

Posted in Currency Trading

 

Does hedging a currency carry trade (long currencies with high interest rates and short currencies with low interest rates) to suppress its volatility enhance performance? In their December 2012 working paper entitled “Carry Trade and Systemic Risk: Why are FX Options So Cheap?”, Ricardo Caballero and Joseph Doyle investigate the profitability of an equally weighted currency carry trade and the effects of hedging associated positions with currency exchange options. The hedged version matches short (long) exchange rate positions with at-the-money call (put) exchange rate options. Using monthly maturity date-matched VIX/VIX futures prices, spot/forward exchange rates for 67 currencies in U.S. dollars and one-month at-the-money option prices for 22 of these currencies (estimated from implied volatilities) during March 2004 (when VIX futures start trading) through August 2012 (96 monthly observations), they find that: (more…)

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