Can Implied Volatility Predict Returns on the Currency Carry Trade?

Posted: 13 Apr 2015 Last revised: 19 Jul 2016

See all articles by Tom Egbers

Tom Egbers

Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE)

Laurens Swinkels

Erasmus University Rotterdam (EUR); Robeco Quantitative Investments

Date Written: March 1, 2015

Abstract

Currency carry strategies have long positions in currencies with a high interest rate and short positions in currencies with a low interest rate. Currency carry strategies have generated about 5.4 percent return per annum (Sharpe ratio: 0.57) over the period December 1996 to May 2014. However, during the recent financial crisis, the carry strategy suffered losses of up to 20 percent on invested capital. We investigate whether investors could have used the implied option volatility index on the US equity market (the VIX) or the option implied volatility index from G7 currencies (the VXY) to time the currency carry trade. We examine a large set of timing strategies and find that for some specific settings excess returns can be as large as 2.5 percent per annum. However, when we take into account that we investigated many trading strategies, these excess returns turn out not to be statistically significant. Hence, our findings cast doubt on implied volatility as a stand-alone timing indicator for currency carry trading in real-life portfolio decisions.

Keywords: Currency carry trade, Exchange rates, Implied Volatility, Market timing, VIX, VXY

JEL Classification: F21, F31, G11, G15

Suggested Citation

Egbers, Tom and Swinkels, Laurens, Can Implied Volatility Predict Returns on the Currency Carry Trade? (March 1, 2015). Journal of Banking and Finance, Vol. 59, pp. 14-26, October 2015, Available at SSRN: https://ssrn.com/abstract=2533327

Tom Egbers

Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE) ( email )

P.O. Box 1738
3000 DR Rotterdam, NL 3062 PA
Netherlands

Laurens Swinkels (Contact Author)

Erasmus University Rotterdam (EUR) ( email )

Burgemeester Oudlaan 50
3000 DR Rotterdam, Zuid-Holland 3062PA
Netherlands

Robeco Quantitative Investments ( email )

Rotterdam, 3000
Netherlands
+31 10 224 2470 (Phone)
+31 10 224 2110 (Fax)

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