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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:

  • After controlling for financial system risk as measured by the roll return from shorting VIX futures, widely used carry trade strategies yield low returns.
  • However, hedging carry trade positions with exchange rate options as specified materially enhances performance. For the available sample, the hedged carry trade generates an annualized gross Sharpe ratio of 0.79, compared to 0.47 for the unhedged strategy.
    • Over the entire sample period, hedging benefits come from both call options on shorted currencies (by boosting returns) and put options on long currencies (by suppressing volatility).
    • Prior to the financial crisis, hedging benefits come mostly from call options on shorted currencies.
  • A strategy involving only exchange rate options designed to hedge carry trade positions may provide cheap insurance against financial system risk. After controlling for this risk (returns from shorting VIX futures), the options strategy generates an annualized gross Sharpe ratio of 1.19.

In summary, evidence indicates that the currency exchange rate options associated with hedging carry trade positions are very cheap, offering strong gross returns and insurance against financial system risk as measured by the return from shorting VIX futures.

Cautions regarding findings include:

  • Currency exchange rate option prices are modeled from implied volatility data rather than actual prices/quotes. Market realities, such as liquidity, may drive actual prices away from modeled ones.
  • Return calculations are gross, not net. Incorporating trading frictions would lower reported returns. Many traders may not be able to access low-cost currency trading vehicles directly (and would have to pay a fund manager for such access).
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