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Trading foreign exchange carry portfolios

Bertolini, Lorenzo (2011). Trading foreign exchange carry portfolios. (Unpublished Doctoral thesis, City University London)


Foreign exchange carry trades involve buying high yielding currencies while selling low yielding currencies. Contrary to the implications of the uncovered interest parity condition, carry trades have generated consistent profits in the past decades. As foreign exchange has gained increased relevance as an asset class in its own, the carry trade emerged as a major driver of foreign exchange market turnover. Given the widespread use and ease of implementation of carry strategies, active currency managers should be evaluated relative to a benchmark which incorporates a proxy for carry trade returns.

Within this thesis we study the profitability of various carry portfolio strategies on a very recent data set ranging from the 1st of January 1999 to the 5th of March 2010. Within three distinct empirical chapters we analyse whether different asset allocation, market-timing and money management methodologies have the potential to improve the performance of a simple carry portfolio, such as the one implemented by the Currency Harvest exchange traded fund by Deutsche Bank.

Three main findings emerge from our investigation on carry trade portfolios. First, we find that a simple carry trade proxy is difficult to outperform with asset allocation and market-timing techniques. Nevertheless, we would not conclude that professional currency managers should cease to implement carry strategies, since they can add value to the investment process by successfully addressing the issue of optimal leveraging for carry trades. Second, we find that the portfolio flows of carry traders do uncover pockets of predictability in the FX market. Strategies which aim at front-running the trades of carry strategies, do generate positive returns with low correlations to traditional carry trade strategies and therefore offer good diversification vehicles for carry portfolios. Lastly, we find that while profitable market-timing seems feasible on historical backtests, the results are strongly dependent on the correctly timing the credit crisis. Thus, we note that our results are affected by a lookback bias. We posit that before the credit crisis, portfolio managers would not have had the foresight to select the correct market-timing indicators. We thus advocate a broad diversification of risk indicators for carry trade timing.

Publication Type: Thesis (Doctoral)
Subjects: H Social Sciences > HG Finance
Departments: Bayes Business School > Finance
Doctoral Theses
Bayes Business School > Bayes Business School Doctoral Theses
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