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Carry Trade and Systemic Risk: Why are FX Options so Cheap?

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  • Ricardo J. Caballero
  • Joseph B. Doyle

Abstract

In this paper we document first that, in contrast with their widely perceived excess returns, popular carry trade strategies yield low systemic-risk-adjusted returns. In particular, we show that carry trade returns are highly correlated with the return of a VIX rolldown strategy —i.e., the strategy of shorting VIX futures and rolling down its term structure— and that the latter strategy performs at least as well as beta-adjusted carry trades, for individual currencies and diversified portfolios. In contrast, hedging the carry with exchange rate options produces large returns that are not a compensation for systemic risk. We show that this result stems from the fact that the corresponding portfolio of exchange rate options provides a cheap form of systemic insurance.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 18644.

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Date of creation: Dec 2012
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Handle: RePEc:nbr:nberwo:18644

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  1. Shanken, Jay, 1992. "On the Estimation of Beta-Pricing Models," Review of Financial Studies, Society for Financial Studies, vol. 5(1), pages 1-33.
  2. Adrien Verdelhan & Hanno Lustig, 2005. "The Cross-Section Of Foreign Currency Risk Premia And Consumption Growth Risk," Boston University - Department of Economics - Working Papers Series WP2005-019, Boston University - Department of Economics.
  3. Burnside, Craig & Eichenbaum, Martin & Rebelo, Sérgio, 2011. "Carry Trade and Momentum in Currency Markets," CEPR Discussion Papers 8343, C.E.P.R. Discussion Papers.
  4. Clarida, Richard & Davis, Josh & Pedersen, Niels, 2009. "Currency carry trade regimes: Beyond the Fama regression," Journal of International Money and Finance, Elsevier, vol. 28(8), pages 1375-1389, December.
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  6. A. Craig Burnside & Martin S. Eichenbaum & Isaac Kleshchelski & Sergio Rebelo, 2008. "Do Peso Problems Explain the Returns to the Carry Trade?," NBER Working Papers 14054, National Bureau of Economic Research, Inc.
  7. François Gourio & Michael Siemer & Adrien Verdelhan, 2011. "International Risk Cycles," NBER Working Papers 17277, National Bureau of Economic Research, Inc.
  8. Fama, Eugene F., 1984. "Forward and spot exchange rates," Journal of Monetary Economics, Elsevier, vol. 14(3), pages 319-338, November.
  9. Engel, Charles, 1996. "The forward discount anomaly and the risk premium: A survey of recent evidence," Journal of Empirical Finance, Elsevier, vol. 3(2), pages 123-192, June.
  10. Fama, Eugene F. & French, Kenneth R., 1993. "Common risk factors in the returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 33(1), pages 3-56, February.
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