Diversification effect of standard and optimized carry trades

Jurij-Andrei Reichenecker

The European Journal of Finance, 2019, vol. 25, issue 8, 745-761

Abstract: Standard carry trades, which consist of purchasing high- and selling low-yield currencies, provide an economic diversification effect. However, the diversification effect is not robust, and is not borne out by much statistical evidence. We introduce optimized carry trades, which incorporate risk components such as currency volatility or currency skewness in the selection process. These optimized carry trades provide a robust economic diversification effect observed by a larger Sharpe ratio, a reduced portfolio volatility, a smaller drawdown, or a reduced tail risk with respect to a benchmark portfolio. Moreover, a significant improvement of the mean-efficient frontier is observable, with the result that minimum-variance and tangency portfolio are enhanced. The empirical results reveal that optimized carry trades have a larger diversification effect than standard carry trades and their modifications.

Date: 2019
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DOI: 10.1080/1351847X.2018.1539023

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