Carry Trade and Systemic Risk: Why are FX Options so Cheap?
AbstractIn 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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Bibliographic InfoPaper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 18644.
Date of creation: Dec 2012
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Find related papers by JEL classification:
- F31 - International Economics - - International Finance - - - Foreign Exchange
- G01 - Financial Economics - - General - - - Financial Crises
- G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
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