Crash-Neutral Currency Carry Trades

Abstract:     
Currency carry trades exploiting violations of uncovered interest rate parity in G10 currencies have historically delivered significant excess returns with annualized Sharpe ratios nearly twice that of the U.S. equity market (1990-2008). Using data on foreign exchange options, this paper investigates whether these returns represent compensation for exposure to currency crashes. After eliminating net dollar exposure and hedging crash risk, excess returns to crash-neutral currency carry trades are statistically indistinguishable from zero; returns to non-dollar-neutral portfolios remain positive, but are only weakly significant. The choice of option maturity has a significant impact on the realized excess returns, with quarterly hedging producing annualized returns that are 1-2% higher than those obtained from monthly hedging.

Keywords: currency carry trade, crash risk, foreign exchange option, forward premium anomaly, uncovered interest parity (UIP)

JEL Classifications: F31, G12

Working Paper Series