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Can implied volatility predict returns on the currency carry trade?

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  • Egbers, Tom
  • Swinkels, Laurens

Abstract

Currency carry strategies have long positions in currencies with a high interest rate and short positions in currencies with a low interest rate. Currency carry strategies have generated about 5.4% return per annum (Sharpe ratio: 0.57) over the period December 1996 to May 2014. However, during the recent financial crisis, the carry strategy suffered losses of up to 20% on invested capital. We investigate whether investors could have used the implied option volatility index on the US equity market (the VIX) or the option implied volatility index from G7 currencies (the VXY) to time the currency carry trade. We examine a large set of timing strategies and find that for some specific settings excess returns can be as large as 2.5% per annum. However, when we take into account that we investigated many trading strategies, these excess returns turn out not to be statistically significant. Hence, our findings cast doubt on implied volatility as a stand-alone timing indicator for currency carry trading in real-life portfolio decisions.

Suggested Citation

  • Egbers, Tom & Swinkels, Laurens, 2015. "Can implied volatility predict returns on the currency carry trade?," Journal of Banking & Finance, Elsevier, vol. 59(C), pages 14-26.
  • Handle: RePEc:eee:jbfina:v:59:y:2015:i:c:p:14-26
    DOI: 10.1016/j.jbankfin.2015.04.026
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    References listed on IDEAS

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    Cited by:

    1. Holger Fink & Yulia Klimova & Claudia Czado & Jakob Stober, 2016. "Regime switching vine copula models for global equity and volatility indices," Papers 1604.05598, arXiv.org.
    2. Holger Fink & Yulia Klimova & Claudia Czado & Jakob Stöber, 2017. "Regime Switching Vine Copula Models for Global Equity and Volatility Indices," Econometrics, MDPI, Open Access Journal, vol. 5(1), pages 1-38, January.
    3. repec:eee:jimfin:v:85:y:2018:i:c:p:1-19 is not listed on IDEAS

    More about this item

    Keywords

    Currency carry trade; Exchange rates; Implied volatility; Market timing; VIX; VXY;

    JEL classification:

    • F21 - International Economics - - International Factor Movements and International Business - - - International Investment; Long-Term Capital Movements
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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