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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. David K. Backus, 2001. "Affine Term Structure Models and the Forward Premium Anomaly," Journal of Finance, American Finance Association, American Finance Association, vol. 56(1), pages 279-304, 02.
  2. Craig Burnside & Martin S. Eichenbaum & Sergio Rebelo, 2011. "Carry Trade and Momentum in Currency Markets," NBER Working Papers 16942, National Bureau of Economic Research, Inc.
  3. Shanken, Jay, 1992. "On the Estimation of Beta-Pricing Models," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 5(1), pages 1-33.
  4. A. Craig Burnside & Martin Eichenbaum & Isaac Kleshchelski & Sergio T. Rebelo, 2010. "Do Peso Problems Explain the Returns to the Carry Trade?," Working Papers, Duke University, Department of Economics 10-44, Duke University, Department of Economics.
  5. Fama, Eugene F. & French, Kenneth R., 1993. "Common risk factors in the returns on stocks and bonds," Journal of Financial Economics, Elsevier, Elsevier, vol. 33(1), pages 3-56, February.
  6. Charles Engel, 1995. "The Forward Discount Anomaly and the Risk Premium: A Survey of Recent Evidence," NBER Working Papers 5312, National Bureau of Economic Research, Inc.
  7. Clarida, Richard & Davis, Josh & Pedersen, Niels, 2009. "Currency carry trade regimes: Beyond the Fama regression," Journal of International Money and Finance, Elsevier, Elsevier, vol. 28(8), pages 1375-1389, December.
  8. Hanno Lustig & Adrien Verdelhan, 2007. "The Cross Section of Foreign Currency Risk Premia and Consumption Growth Risk," American Economic Review, American Economic Association, American Economic Association, vol. 97(1), pages 89-117, March.
  9. Emmanuel Farhi & Samuel Paul Fraiberger & Xavier Gabaix & Romain Ranciere & Adrien Verdelhan, 2009. "Crash Risk in Currency Markets," NBER Working Papers 15062, National Bureau of Economic Research, Inc.
  10. François Gourio & Michael Siemer & Adrien Verdelhan, 2011. "International Risk Cycles," NBER Working Papers 17277, National Bureau of Economic Research, Inc.
  11. Fama, Eugene F., 1984. "Forward and spot exchange rates," Journal of Monetary Economics, Elsevier, Elsevier, vol. 14(3), pages 319-338, November.
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