From Carry Trades to Curvy Trades

41 Pages Posted: 8 May 2018

See all articles by Ferdinand Dreher

Ferdinand Dreher

University of Groningen

Johannes Gräb

European Central Bank (ECB)

Thomas Kostka

European Central Bank (ECB)

Multiple version iconThere are 2 versions of this paper

Date Written: May 2, 2018

Abstract

Traditional carry trade strategies are based on differences in short-term interest rates, neglecting any other information embedded in yield curves. We derive return distributions of carry trade portfolios among G10 currencies, where the signals to buy and sell currencies are based on summary measures of the yield curve, the Nelson-Siegel factors. We nd that a strategy based on the relative curvature factor, the curvy trade, yields higher Sharpe ratios and a smaller return skewness than traditional carry trade strategies. Curvy trades build less upon the typical carry currencies, like the Japanese yen and the Swiss franc, and are hence less susceptible to crash risk. In line with that, standard pricing factors of traditional carry trade returns, such as exchange rate volatility, fail to explain curvy trade returns in a linear asset pricing framework. Our fi ndings are in line with recent interpretations of the curvature factor. A relatively high curvature signals a relatively higher path of future short-term rates over the medium-term putting upward pressure on the currency.

Keywords: currency carry trades, yield curve, Nelson-Siegel factors

JEL Classification: C23, C53, G11

Suggested Citation

Dreher, Ferdinand and Grab, Johannes and Kostka, Thomas, From Carry Trades to Curvy Trades (May 2, 2018). ECB Working Paper No. 2149, Available at SSRN: https://ssrn.com/abstract=3172710

Ferdinand Dreher

University of Groningen

P.O. Box 800
9700 AH Groningen, Groningen 9700 AV
Netherlands

Johannes Grab

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Thomas Kostka (Contact Author)

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

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