Trading foreign exchange portfolios with volatility filters: the carry model revisited

Abstract

The rejection of the simple risk-neutral efficient market hypothesis in the foreign exchange (FX) market opens the possibility of the profitable use of a carry model taking full advantage of interest rate differentials to trade currencies. A first motivation for this paper is to study whether a simple passive carry model can outperform a typical currency fund manager replicated by dynamic technical moving average convergence and divergence (MACD) models as in Lequeux and Acar (1998). Secondly, we study whether the addition of volatility filters can further improve the carry model performance. We consider the period starting from the introduction of the Euro (EUR) on 4 January 1999 to 31 March 2005 (1620 datapoints). To assess the consistency of the carry model performance on a portfolio of the nine most heavily traded exchange rates, the whole review period is further split into two sub-periods. Our results show that in the three periods considered and after inclusion of transaction costs, the simple carry model performs much better than the benchmark MACD model in terms of annualized return, risk-adjusted return and maximum potential loss, while a combined carry/MACD model has the lowest trading volatility. Moreover, the addition of two volatility filters adds significant value to the performance of the three models studied.

Leveraged Carry Trade Portfolios

“…Farhi and Gabaix (2008) present a comprehensive survey of the more recent literature and also propose a new solution based on a model in which rare worldwide disasters can occur and affect each country's productivity. Carry trade, which is the other side of the coin, has been frequently discussed by the financial press, but also some papers in the academic literature have pointed out that carry trade positions yield profits when maintained over long periods (e.g., Thomas 1986;Burnside, Eichenbaum and Rebelo 2007;Dunis and Miao 2007;Pukthuanthong, Thomas and Bazan 2007;Villanueva 2007;Brunnermeier, Nagel and Pedersen 2008;Burnside, Eichenbaum, Kleshchelski andRebelo 2008, Jurek, 2008). 1 Most of these studies have examined the strategy without leverage.…”

Using extracted forward rate term structure information to forecast foreign exchange rates

“…Further to this, the results reinforce the rejection of the risk neutral ecient market hypothesis. Elliott and Ito (1999) and Dunis and Miao (2007) highlight how even small pockets of predictability can be exploited protably. Our study provides additional informal evidence supporting the view that exchange rates are indeed predictable to some degree with an assessment of protability of the scalar response framework leading to positive cumulative returns for two of the three currency pairs considered.…”

Forecasting-Based Carry Trade Using Pegged Currency: A Case of Omani Rial

“…Carry trade is a lucrative strategy that is so popular among all levels of investors from housewives to global hedge funds due to its simplicity and return that is similar to the S&P 500 according to Burnside et al (2006), Duni and Miao (2007), Moosa (2008), Darvas (2009), Menkhoff et al (2012), and Jurek (2014). Adding to its attractive returns it is seen as less risky than the equity stocks producing a better Sharpe ratio according to Gyntelberg and Remolona (2007).…”