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Forecasting Covariance for Optimal Carry Trade Portfolio Allocations

5 Pages Posted: 7 Jan 2016  

Matthew Ames

University College London - Department of Statistical Science

Guillaume Bagnarosa

ESC Rennes

Gareth William Peters

Department of Actuarial Mathematics and Statistics, Heriot-Watt University; University of 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

Pavel V. Shevchenko

Macquarie University

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 Bagnarosa, Guillaume and Peters, Gareth William 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)

University College London - Department of Statistical Science ( email )

Gower Street
London, WC1E 6BT
United Kingdom

Guillaume Bagnarosa

ESC Rennes ( email )

2, RUE ROBERT D'ARBRISSEL
Rennes, 35065
France

Gareth William 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 of 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

Pavel V. Shevchenko

Macquarie University ( email )

North Ryde
Sydney, New South Wales 2109
Australia

HOME PAGE: http://www.businessandeconomics.mq.edu.au/contact_the_faculty/all_fbe_staff/pavel_shevchenko

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