Upside and Downside Risk Exposures of Currency Carry Trades via Tail Dependence

19 Pages Posted: 18 Jun 2014

See all articles by Matthew Ames

Matthew Ames

The Institute of Statistical Mathematics

Gareth Peters

Department of Actuarial Mathematics and Statistics, Heriot-Watt University; University College London - Department of Statistical Science; University of Oxford - Oxford-Man Institute of Quantitative Finance; London School of Economics & Political Science (LSE) - Systemic Risk Centre; University of New South Wales (UNSW) - Faculty of Science

Guillaume Bagnarosa

ESC Rennes School of Business

Ioannis Kosmidis

Department of Statistical Science, University College London

Date Written: June 17, 2014

Abstract

Currency carry trade is the investment strategy that involves selling low interest rate currencies in order to purchase higher interest rate currencies, thus profiting from the interest rate differentials. This is a well known financial puzzle to explain, since assuming foreign exchange risk is uninhibited and the markets have rational risk-neutral investors, then one would not expect profits from such strategies. That is, according to uncovered interest rate parity (UIP), changes in the related exchange rates should offset the potential to profit from such interest rate differentials. However, it has been shown empirically, that investors can earn profits on average by borrowing in a country with a lower interest rate, exchanging for foreign currency, and investing in a foreign country with a higher interest rate, whilst allowing for any losses from exchanging back to their domestic currency at maturity. This paper explores the financial risk that trading strategies seeking to exploit a violation of the UIP condition are exposed to with respect to multivariate tail dependence present in both the funding and investment currency baskets. It will outline in what contexts these portfolio risk exposures will benefit accumulated portfolio returns and under what conditions such tail exposures will reduce portfolio returns.

Keywords: Currency carry trade, Multivariate tail dependence, Forward premium puzzle, Mixture models, Generalized Archimedean copula

JEL Classification: G12, G14, C58, C32

Suggested Citation

Ames, Matthew and Peters, Gareth and Bagnarosa, Guillaume and Kosmidis, Ioannis, Upside and Downside Risk Exposures of Currency Carry Trades via Tail Dependence (June 17, 2014). Available at SSRN: https://ssrn.com/abstract=2454815 or http://dx.doi.org/10.2139/ssrn.2454815

Matthew Ames (Contact Author)

The Institute of Statistical Mathematics ( email )

Tokyo
Japan

Gareth Peters

Department of Actuarial Mathematics and Statistics, Heriot-Watt University ( email )

Edinburgh Campus
Edinburgh, EH14 4AS
United Kingdom

HOME PAGE: http://garethpeters78.wixsite.com/garethwpeters

University College London - Department of Statistical Science ( email )

1-19 Torrington Place
London, WC1 7HB
United Kingdom

University of Oxford - Oxford-Man Institute of Quantitative Finance ( email )

University of Oxford Eagle House
Walton Well Road
Oxford, OX2 6ED
United Kingdom

London School of Economics & Political Science (LSE) - Systemic Risk Centre ( email )

Houghton St
London
United Kingdom

University of New South Wales (UNSW) - Faculty of Science ( email )

Australia

Guillaume Bagnarosa

ESC Rennes School of Business ( email )

2, RUE ROBERT D'ARBRISSEL
Rennes, 35065
France

Ioannis Kosmidis

Department of Statistical Science, University College London ( email )

Gower Street
London, WC1E 6BT
United Kingdom

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