Abstract

http://ssrn.com/abstract=2188195
 
 

References (23)



 
 

Citations (2)



 
 

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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


Cornerstone Research

December 5, 2012

MIT Department of Economics Working Paper No. 12-28

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 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

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Date posted: December 12, 2012  

Suggested Citation

Caballero, Ricardo J. and Doyle, Joseph B., Carry Trade and Systemic Risk: Why are FX Options So Cheap? (December 5, 2012). MIT Department of Economics Working Paper No. 12-28. Available at SSRN: http://ssrn.com/abstract=2188195 or http://dx.doi.org/10.2139/ssrn.2188195

Contact Information

Ricardo J. Caballero (Contact Author)
Massachusetts Institute of Technology (MIT) - Department of Economics ( email )
50 Memorial Drive
E52-252A
Cambridge, MA 02142
United States
617-253-0489 (Phone)
617-253-1330 (Fax)
National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
Joseph B. Doyle
Cornerstone Research ( email )
699 Boylston St.
Boston, MA 02116
United States
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