Carry Trade and Systemic Risk: Why are FX Options So Cheap?
Ricardo J. Caballero
Massachusetts Institute of Technology (MIT) - Department of Economics; National Bureau of Economic Research (NBER)
Joseph B. Doyle
December 5, 2012
MIT Department of Economics Working Paper No. 12-28
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 betaadjusted 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.
Number of Pages in PDF File: 45
Keywords: carry trade, forward premium puzzle, vix futures and rolldown, interest parity condition, Fama-French factors
JEL Classification: F31, G01, G15
Date posted: December 12, 2012
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