Carry Trade and Systemic Risk: Why are FX Options so Cheap?
45 Pages Posted: 22 Dec 2012 Last revised: 12 Jun 2022
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Carry Trade and Systemic Risk: Why are FX Options So Cheap?
Date Written: December 2012
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 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.
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