Carry Trade and Systemic Risk: Why are FX Options so Cheap? / Ricardo J. Caballero, Joseph B. Doyle.

Format:

Book

Author/Creator:

Caballero, Ricardo J.

Contributor:

National Bureau of Economic Research.

Doyle, Joseph B.

Series:

Working Paper Series (National Bureau of Economic Research) no. w18644.

NBER working paper series no. w18644

Language:

English

Physical Description:

1 online resource: illustrations (black and white);

Place of Publication:

Cambridge, Mass. National Bureau of Economic Research 2012.

Summary:

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 beta-adjusted 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.

Notes:

Print version record

December 2012.