Volatility and the Carry Trade

27 Pages Posted: 5 Nov 2007

Abstract

The currency 'carry trade', in which an investor buys assets in a higher yielding currency by borrowing in a lower yielding currency, has been consistently exploited as a source of profits by investors. In this paper, we discuss the effectiveness of the carry trade as prospective risk (measured by implied volatilities) in exchange rates varies. Based on simple equilibrium arguments we propose the hypothesis that the carry trade is effectively a form of short volatility trade. We also explore a simple strategy that combines carry with options and present a heuristic statistic for the measurement of the economics of the carry trade. We test the stratgy on actual historical carry and option price data and find that the hypothetical strategy allows for the presence of arbitrage opportunities between the forex option and carry markets.

Keywords: carry trade, volatility

JEL Classification: E44, F31, G12

Suggested Citation

Bhansali, Vineer, Volatility and the Carry Trade. Journal of Fixed Income, Winter 2007. Available at SSRN: https://ssrn.com/abstract=1025532

Vineer Bhansali (Contact Author)

LongTail Alpha, LLC ( email )

500 Newport Center Drive
Suite 820
Newport Beach, CA 92660
United States

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