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Risks of the Carry Trade

Risks of the Carry Trade

Coauthor(s): Hodrick, Robert, Kent Daniel and Zhongjin Lu

We examine the returns to various carry trade portfolios formed from G10 currencies. We find that Sharpe ratios of carry trades range from 0.36 to 0.78 when varying the choices of the benchmark currency. Risk matters, as a dollar-neutral carry trade exhibit an insignificant alpha in the Fama-French three-factor model. The weighting of currencies also matters, as spread-weighted or risk-rebalanced carry trades exhibit significant alphas that cannot be explained by the Fama-French three-factor model or the two-factor FX model. When hedged with options, such portfolios still earn significant alphas against the Fama-French three-factor model while exhibiting little skewness. Lastly, we use the daily returns to calculate the maximum losses for different horizons. We find that the maximum loss over one month or one quarter rejects the i.i.d. assumption underlying a bootstrap at the 5% level, indicating that autocorrelation in the downside may contribute to the negative skewness of the longer horizon returns.

Exact Citation:
Hodrick, Robert, Kent Daniel and Zhongjin Lu "Risks of the Carry Trade." , Columbia Business School, (2013).
Date: 2013