Forecasting Covariance for Optimal Carry Trade Portfolio Allocations

5 Pages Posted: 7 Jan 2016

See all articles by Matthew Ames

Matthew Ames

ResilientML; The Institute of Statistical Mathematics

Guillaume Bagnarosa

ESC Rennes School of Business

Gareth Peters

University of California Santa Barbara; affiliation not provided to SSRN

Pavel V. Shevchenko

Macquarie University - Department of Actuarial Studies and Business Analytics

Date Written: January 6, 2016

Abstract

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

Suggested Citation

Ames, Matthew and Ames, Matthew and Bagnarosa, Guillaume and Peters, Gareth and Shevchenko, Pavel V., Forecasting Covariance for Optimal Carry Trade Portfolio Allocations (January 6, 2016). Available at SSRN: https://ssrn.com/abstract=2711586 or http://dx.doi.org/10.2139/ssrn.2711586

Matthew Ames (Contact Author)

The Institute of Statistical Mathematics ( email )

Tokyo
Japan

ResilientML ( email )

Melbourne
Australia

Guillaume Bagnarosa

ESC Rennes School of Business ( email )

2, RUE ROBERT D'ARBRISSEL
Rennes, 35065
France

Gareth Peters

University of California Santa Barbara ( email )

Santa Barbara, CA 93106
United States

affiliation not provided to SSRN

Pavel V. Shevchenko

Macquarie University - Department of Actuarial Studies and Business Analytics ( email )

Australia

HOME PAGE: http://www.mq.edu.au/research/centre-for-risk-analytics/pavel-shevchenko

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