Ailing WangShu-Wei Pei Group No. 2Kwadwo OkohJean Lemercier

International FinanceCarry Trade

OutlineSingle currency pair carry trade

Single currency pair using options implied volatility as a signal

Equally weighted portfolio carry trade

Portfolio carry trade using options implied volatility as a signal

Performance comparison

Drawbacks of the signals

Conclusion

Data Selection 9 Countries selected from G20-France, Japan, US, Australia, UK, Sweden, Swiss, New Zealand and Norway-Comparable economy, less inflation risk and less volatile exchange rate

movements

Data Studied from 2002-2013- Two sections: Jan 2002-Dec 2006 and Jan 2007-Dec 2013

Data obtained from DataStream or Bloomberg- One Month T-bill interest rate

Initial investment of $100,000, rebalanced monthly

Single currency pair carry trade

Each period, Starts with USD $100,000…

1. Borrow equivalent amount in low interest rate currency (funding currency)

2. Exchange proceeds into a high interest rate currency (investing currency)

3. Invest in an asset with maturity matching tenor of the borrowing

4. Exchange proceeds of investment back into funding currency and repay debt and end of the month

5. Surplus (deficit) in funding currency is then exchanged into USD

Repeat…[1]

[1] International Finance Lecture Slide 42

Year 2002 2003 2004 2005 2006Average Return

Standard Deviation

Annual Return (%)

24.39 10.95 11.33 14.80 12.26 14.74% 5.60%

Year 2007 2008 2009 2010 2011 2012 2013

Average Return

Standard Deviation

Annual Return (%) 6.76 -40.35 41.78 6.54 11.92 -1.88 -9.41 2.19% 24.71%

Simple Carry Trade annual return for periods 2002-2006 and 2007-2013

Jan 2002 - Dec 2006Average annual return = 14.74% Standard Deviation = 5.6%

Jan 2007 - Dec 2013Average annual return = 2.19% Standard Deviation = 24.7%

Carry trade using options implied volatility as a signal

Setting upper and lower implied volatility boundsPast 5Y data

Implementing a volatility factorLeverage 2:1 when implied volatility is lowNo change if implied volatility is averageNo carry trade when implied volatility is high

Example:30/04/2002 Trade 100,000 USD equiv. * 2 = 200,000

30/09/2002 Usual carry trade size = 100,000 USD31/08/2007 No carry trade for the month (*0)

Historical Data AUD/JPY

Implied volatility31/12/1996 11.6631/01/1997 14.45

… …31/12/2001 12.43

Average 14.66Sdeviation 1.83

Upper bound 18.34Lower bound 10.99

Actual AUD/JPY implied volatility

30/04/20029.7

(9.7<10.99)x2

30/09/2002 11.85 x1

31/08/200722.25

(22.25>18.34)x0

Equally weighted currency pairEach period, Starts with USD $100,000…

1. Rank interest rates from lowest to highest and group the lowest third as borrowing portfolio and the highest third as investment portfolio

2. Borrow equal USD equivalent amounts from each country in the borrowing portfolio

3. Change these amounts to USD, and invest equal USD equivalent amounts in each country in the investment portfolio

4. Exchange proceeds of investment back into USD and repay debt at the end of the month

5. Surplus (deficit) is maintain in USD

Repeat…[1]

Portfolio carry trade using options implied volatility

Implementing a volatility factor per currencyHigher weighting when implied volatility is lowNo change in weights if implied volatility is averageZero weighting when implied volatility is high

Implementing a volatility factor per portfolioEqual weighting when all have low implied volatilityEqual weighting when all have average implied volatility No carry trade when all have high implied volatility

Example:30/04/2013 Weighting above 1/3 for NOK

31/10/2002 Weighting equal 1/3 for NOK31/12/2007 Zero weight for NOK

Actual NOK/USDimplied volatility

30/04/20138.6

(8.6<8.96)x2

31/10/2002 10.15 x1

31/12/200712.85

(12.85>12.57)x0

Portfolio Carry Trade annualised returns, standard deviations and sharpe ratios for periods 2002-2006 and 2007-2013

Equally Weighted Signal-based

2002-2006 2007-2013 2002-2013 2002-2006 2007-2013 2002-2013

Annualised average return

14.82% 10.40% 12.24% 15.13% 8.88% 11.48%

Standard deviation

5.48% 15.56% 12.17% 7.34% 9.82% 9.08%

Sharpe ratio

2.428 0.571 0.881 1.855 0.749 1.0967

Performance comparison

  

One pair carry Trade

One pair carry

trade with signal

Portfolio carry trade

Portfolio carry trade

with signals US equities[1]

Yearly average return (02-13) 7.42% 8.84% 12.24% 11.48% 7.82%

Yearly standard dev. (02-13) 19.65% 12.50% 12.17% 9.08% 16%

Sharpe Ratio 0.30 0.59 0.881 1.0967 0.39Risk adjusted return 6.33% 10.89% 15.61% 19.07% 7.82%

Risk Free return (4 week T-bills annualized) 1.52% 1.52% 1.52% 1.52% 1.52%

Performance comparison (2)

Performance comparison (3)

ConclusionThe carry trade with signals : a rational investment option

BUTSample variability issueImplied volatility ≠ realised vol.Implied volatility and upward/downward movementsTransaction costs

Investigate other signals – Delta risk reversalA good diversification tool