Carry trade hedge strategy
On a recent post I talked about ways in which you carry trade hedge strategy reduce the influence of swap rates in your Forex automated trading strategy or at least implement them in a way that reflects the worst possible case. Historically these strategies have had several problems that we will carry trade hedge strategy through the article as well as ways in which we can alleviate and potentially completely eliminate the crash-risk associated with the Forex carry trade.
When you lend a currency pair with a higher interest rate by borrowing a currency with a lower interest rate you gain the difference between the borrowing and lending rates of these two currencies. Interest rate parity would predict that the higher interest rate currency would depreciate against the lower interest rate currency such that an investor sees no difference between holding any of the two while in reality we tend to see an increase in the value of the high interest rate currency, an unexplained forward premium that should not exist.
In summary you want to hold a currency with a very low borrowing rate against a currency with a very high lending rate, the higher the spread between these two values the more profitable your swap credits will be. In we saw a scenario of this nature where the leveraged G10 carry trade strategy — which had a Sharpe ratio of more than 0. Even more the event did not account for the entire forward premium anomaly and therefore several economists carry trade hedge strategy that the forward premium anomaly is still compensating for a yet to come market event.
Carry trade hedge strategy this said if there is a substantial sensitivity to market crashes it is interesting to consider strategies where the crash risk is reduced or completely eliminated.
In his paper Jakub W. Jurek explores the use of crash-neutral currency carry trade strategies and how they compare with the regular unhedged carry trade. He uses either delta neutral or cash neutral options to hedge the crash risk of a carry trade portfolio either partially or totally. On the image below from his paper you can see his results for a G10, USD based carry trade strategy carry trade hedge strategy different hedging strategies up to December You can see how the option hedging introduces large additional costs into the carry trade strategy with the premiums being higher as you move to more protection.
The drop in the drawdown and return is almost entirely proportional, meaning that the Sharpe is fairly constant. Burnside et al also explore hedging in their paper on the peso problem and the return of the carry trade. They show how options hedging strongly narrows the distribution of returns of the carry trade and eliminates the fat tail risk. Caballero and Joseph B. Doyle expanded on the concept of option hedged carry trade strategies on their paper.
In this paper they use simple at the money ATM monthly options to hedge the risk of different carry trade portfolios. Carry trade hedge strategy the end they find that incredibly good results are obtained when you use a quintile composed of only the highest carry trade yielding currencies. In this portfolio the dramatic reduction in the drawdown in justifies the additional costs in option premiums to hedge the portfolio results.
This is possible because option pricing does not work when there are carry trade hedge strategy from the Black-Scholes model. In this model option prices are based on expected future volatility but these estimations of volatility are the wrongest just before market crisis events which are — by their very nature — unforeseen.
This results in the fact that option based carry trade hedging is in fact the cheapest when you need it the most, especially for the highest interest yielding pairs. The observation that options are mispriced in the Forex market is actually not new.
A recent study in the carry trade hedge strategy between put and call options in FX shows that the symmetry between the two is not perfect, something that stems from the existence of the forward rate. The carry trade has some other special properties that we can exploit. While markowitz balancing of traditional FX trading strategies does not work due to the estimation error in future system correlations the future estimation error in carry trade setups is much less prominent due to the fact that future interest rate differentials carry trade hedge strategy predictable to a significant degree.
This means that mean variance optimization of carry trade portfolios actually yields consistently better out of sample results than naive optimizations. Pedro Barroso and Pedro Santa-Clara show this phenomenon very clearly carry trade hedge strategy their paper on optimal currency portfolios. The carry trade is a very interesting strategy that can provide a significant source of diversification against traditional stock and bond investments. By using options to hedge risk and carry trade hedge strategy choosing the basket of currencies to trade one can obtain even better results that can even totally eliminate the fat-tail risk associated with market crashes even if this comes at the cost of some accumulated return which can be recovered by using a higher leverage in most cases.
Although the traditional carry trade is far from perfect recent research suggestions make it an extremely attractive strategy. Mail will not be published required.
Mechanical Forex Trading in the FX market using mechanical trading strategies. Hedged Forex Carry Trade Strategies: An Overview February 8th, No Comments. Posted in Articles Tags: Building an algorithmic trading plan: Leave a Reply Click here to cancel reply.
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