The Foreign Exchange Carry Trade
Degree GrantorUniversity of Canterbury
Degree NameDoctor of Philosophy
I examine the foreign exchange (FX) carry trade, using both single currency and portfolio construction techniques. Chapter I looks at the background, the mechanics of constructing the FX carry trade, and the returns that it generates. In addition the behaviour of these returns is examined in the context of uncovered interest rate parity and several time series analysis aspects. Chapter II introduces both a theoretical stop-loss framework and a sample of hedge fund risk management policies obtained from industry sources. These stop-loss policies are then superimposed onto the FX carry trade. Although ’naive’ returns to the FX carry trade, as documented elsewhere in the literature are strongly positive, allowing for stop-loss rules results in returns that are insignificantly different from zero. The ability to cash in on the much vaunted forward premium puzzle relies on being able to stay in the trade, which seems strongly at odds with industry risk management policies. The stop loss signals generated are modelled using available currency futures data and client segmentation categories, but fails to establish a meaningful relationship. Chapter III extends the already established link between the returns to the FX carry trade and historical volatility measures to that of the entire FX option implied volatility surface. The quotation conventions and mechanics of trading FX options are explained and despite being able to establish a strong contemporaneous relationship between FX carry trade returns and FX option implied volatility surfaces, this is not able to be extended to predicting future FX carry trade returns.