Beyond the Carry Trade: Optimal Currency Portfolios
UNSW Australia Business School, School of Banking and Finance
New University of Lisbon - Nova School of Business and Economics; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)
June 24, 2012
Journal of Financial and Quantitative Analysis (JFQA), Vol. 50, No. 5, 2015
We test the relevance of technical and fundamental variables in forming currency portfolios. Carry, momentum and reversal all contribute to portfolio performance, whereas the real exchange rate and the current account do not. The resulting optimal portfolio outperforms the carry trade and other naive benchmarks in an extensive 16 year out-of-sample test. Its returns are not explained by risk and are valuable to diversified investors holding stocks and bonds. Exposure to currencies increases the Sharpe ratio of diversified portfolios by 0.5 on average, while reducing crash risk. We argue that currency returns are an anomaly which is gradually being corrected as hedge fund capital increases.
The appendix may be found here: http://ssrn.com/abstract=2771667.
Number of Pages in PDF File: 43
Keywords: forward rate premium, carry trade, currency market, optimal portfolios
JEL Classification: F31, G11, G12
Date posted: April 18, 2012 ; Last revised: May 1, 2016