Using carry trade as a defense against volatility

Daniel Sven Olof Hammarstrand Hansson

Master's thesis

Abstract:

The foreign exchange market, with its exceptional daily turnover, continues to intrigue investors, economists, and policymakers. This study seeks to untangle the complexities of this volatile market and specifically examines the viability of carry trades as a defense against market volatility. Using four G10 currency pairs, historical data on foreign exchange rates, interest rates, Volatility Index (VIX) values, GDP per worker, and current account balances, this research studies the factors influencing carry trade performance and exchange rate changes. This study suggests that the Sharpe Ratio does fluctuate during times of volatility, and shorter-term carry trades yield higher Sharpe Ratios. However, no significant correlation was found between exchange rate changes and the VIX index, interest rate differentials, or the VIX index and interest rate differentials. While the VIX index and some interest differentials may provide some predictive value for certain currency pair exchange rates, their usage must be approached with caution. Ultimately, this research highlights the potential of carry trades, but also underscores their risks and the need for further investigation into enhancing their profitability during periods of high market volatility.

Abstract:

The foreign exchange market, with its exceptional daily turnover, continues to intrigue investors, economists, and policymakers. This study seeks to untangle the complexities of this volatile market and specifically examines the viability of carry trades as a defense against market volatility. Using four G10 currency pairs, historical data on foreign exchange rates, interest rates, Volatility Index (VIX) values, GDP per worker, and current account balances, this research studies the factors influencing carry trade performance and exchange rate changes. This study suggests that the Sharpe Ratio does fluctuate during times of volatility, and shorter-term carry trades yield higher Sharpe Ratios. However, no significant correlation was found between exchange rate changes and the VIX index, interest rate differentials, or the VIX index and interest rate differentials. While the VIX index and some interest differentials may provide some predictive value for certain currency pair exchange rates, their usage must be approached with caution. Ultimately, this research highlights the potential of carry trades, but also underscores their risks and the need for further investigation into enhancing their profitability during periods of high market volatility.

Keywords

VIX, Sharpe Ratio, Financial econometrics, Uncovered Interest Parity, Carry trade, Interest rate differential, Volatility, FX market, Exchange rate

Keywords

Interest rate differential, Volatility, VIX, Sharpe Ratio, FX market, Exchange rate, Financial econometrics, Uncovered Interest Parity, Carry trade

Language used: English

Date on which the thesis was submitted / produced: 21. 5. 2023

Thesis defence

• Date of defence: 16. 6. 2023
• Supervisor: Karel Brůna
• Reader: Ondřej Šíma

Vysoká škola ekonomická v Praze

Master programme:
Finance and Accounting