Carry Trade and Systemic Risk: Why are FX Options so Cheap?
Name
Caballero12-28.pdf
Size
2.01 MB
Format
Adobe PDF
Checksum (MD5)
8c34d1d50590d2979ead0dc898268bd3
Author(s)
Caballero, Ricardo
Doyle, Joseph B.
Date Issued
December 5, 2012
Publisher
Cambridge, MA: Department of Economics, Massachusetts Institute of Technology
Series/Report no.
Working paper, Massachusetts Institute of Technology, Dept. of Economics;12-28
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 betaadjusted 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.
Subjects
Carry trade
forward premium puzzle
vix futures and rolldown
interest parity condition
Fama-French factors
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