Diversified Carry Trade Strategy

Investment Summary
The Diversified Carry Trade Strategy builds a diversified carry trade portfolio by investing equal dollar amounts in each of the 9 most liquid currencies (Australian Dollar (AUD), Canadian Dollar (CAD), Euro (EUR), Japanese Yen (JPY), British Pound (GBP), Swiss Franc (CHF), Norwegian Krone (NOK), New Zealand Dollar (NZD), Swedish Krona (SEK)) on a monthly basis.

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Investment Performance (Good Investment Selection Guide)
Investment Return (?): 4.83% Volatility (?): 4.76% Sharpe Ratio: 1.01 Maximum Drawdown: -8.5%

Investment’s Fundamental Concept:
Carry trade: Carry trade means receiving returns from holding one asset against borrowing another asset.

Carry trade is borrowing in currencies (funding currency) with low interest rates to buy and hold currencies (target currency) with high interest rates. This is interest rate arbitrage between currency pairs.

The investment will be profitable as long as target currency does not weaken against funding currency too greatly to erase the interest rate differential.

Investment’s Logic:

Build a diversified carry trade portfolio by investing equal dollar amounts in each of the 9 most liquid currencies (Australian Dollar (AUD), Canadian Dollar (CAD), Euro (EUR), Japanese Yen (JPY), British Pound (GBP), Swiss Franc (CHF), Norwegian Krone (NOK), New Zealand Dollar (NZD), Swedish Krona (SEK)) on a monthly basis.

Buy currencies with positive carry (If interest rate of the foreign currency is higher than the US rate, you borrow 1 US dollar and buy and hold the foreign currency for a month) and sell those with negative carry (If the interest rate of the foreign currency is lower than US rate, you borrow 1 US dollar worth of foreign currency and buy and hold the US dollar for 1 month) against the US Dollar holding positions for a month.

To avoid market crisis you implement the following risk on / risk off rule: If the level of VIX is higher than 90th percentile of past year’s VIX levels, you do not enter a carry trade.

Between 2001 and 2013 the average annualized return of the portfolio was 4.83% with a low volatility of 4.76% generating a sharpe ratio of 1.01.

FX Carry Trade Risk:

The significant risk of FX Carry Trade Strategies is that exchange rates become very volatile during market crisis. From August 2008 to January 2009, AUDJPY lost 43% and other trade carry pairs like NZDJPY and GBPJPY lost 42% and 39% respectively. Popular carry trades are also highly correlated with other risky assets like the S&P 500. From 2001 to 2013 AUDJPY had correlation of 0.60 with S&P 500. During the 2008 market crisis the correlation increased to 0.75.

Market Risk Indicators: Market Risk Indicators are implemented to filter calm market periods where significant risk losses are small and other periods where market risk is high. When the market is nervous implied volatility rates spike up and this the time to take risk off.

Other Investment Strategy Characteristics:
Investment Type: Statistical Arbitrage Investment Risk: 3/5 Average Backtest Range: 30-40 years Rebalancing period: Daily
Investment Strategy Markets:
  • Australian Dollar (AUD)
  • Canadian Dollar (CAD)
  • Euro (EUR)
  • Japanese Yen (JPY)
  • British Pound (GBP)
  • Swiss Franc (CHF)
  • Norwegian Krone (NOK)
  • New Zealand Dollar (NZD)
  • Swedish Krona (SEK)