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Carry Trade and Systemic Risk: Why are FX Options So Cheap?

45 Pages Posted: 12 Dec 2012  

Ricardo J. Caballero

Massachusetts Institute of Technology (MIT) - Department of Economics; National Bureau of Economic Research (NBER)

Joseph B. Doyle

Cornerstone Research

Multiple version iconThere are 2 versions of this paper

Date Written: December 5, 2012

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.

Keywords: carry trade, forward premium puzzle, vix futures and rolldown, interest parity condition, Fama-French factors

JEL Classification: F31, G01, G15

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: https://ssrn.com/abstract=2188195 or http://dx.doi.org/10.2139/ssrn.2188195

Ricardo J. Caballero (Contact Author)

Massachusetts Institute of Technology (MIT) - Department of Economics ( email )

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National Bureau of Economic Research (NBER)

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Joseph B. Doyle

Cornerstone Research ( email )

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