Beyond the Carry Trade: Optimal Currency Portfolios

43 Pages Posted: 18 Apr 2012 Last revised: 1 May 2016

Pedro Barroso

UNSW Australia Business School, School of Banking and Finance

Pedro Santa-Clara

New University of Lisbon - Nova School of Business and Economics; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Date Written: June 24, 2012

Abstract

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.

Keywords: forward rate premium, carry trade, currency market, optimal portfolios

JEL Classification: F31, G11, G12

Suggested Citation

Barroso, Pedro and Santa-Clara, Pedro, Beyond the Carry Trade: Optimal Currency Portfolios (June 24, 2012). Journal of Financial and Quantitative Analysis (JFQA), Vol. 50, No. 5, 2015. Available at SSRN: https://ssrn.com/abstract=2041460 or http://dx.doi.org/10.2139/ssrn.2041460

Pedro Barroso (Contact Author)

UNSW Australia Business School, School of Banking and Finance ( email )

Sydney, NSW 2052
Australia

Pedro Santa-Clara

New University of Lisbon - Nova School of Business and Economics ( email )

Lisbon
Portugal

HOME PAGE: http://docentes.fe.unl.pt/~psc/

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Centre for Economic Policy Research (CEPR) ( email )

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

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