Forecasting Covariance for Optimal Carry Trade Portfolio Allocations
5 Pages Posted: 7 Jan 2016
Date Written: January 6, 2016
Modelling and forecasting of asset volatility and covariance is of prime importance in the construction of portfolios. In this paper, we present a generalised multi-factor model that incorporates heteroskedasticity and dependence in the idiosyncratic error terms. We apply this model to forecasting the time-varying covariances in a basket of high interest rate and a basket of low interest rate carry trade currencies and then utilise these forecasts for portfolio optimisation. We compare traditional Markowitz portfolio optimisation to the more recently popular risk-based portfolio optimisation. Our model is shown to provide superior risk-adjusted returns for a currency carry trade strategy over the period 1999-2014.
Keywords: Covariance Forecasting, Currency Carry Trade, Covariance Regression, Markowitz Portfolio, Equal Risk Contribution
JEL Classification: C1, C5, F31, G11
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