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

45 Pages Posted: 22 Dec 2012  

Ricardo J. Caballero

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

Joseph B. Doyle

Cornerstone Research

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Date Written: December 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 beta-adjusted 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.

Suggested Citation

Caballero, Ricardo J. and Doyle, Joseph B., Carry Trade and Systemic Risk: Why are FX Options so Cheap? (December 2012). NBER Working Paper No. w18644. Available at SSRN: https://ssrn.com/abstract=2192817

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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