This report examines the benefits and risks of the carry trade strategy over different currency pairs on the 2002-2013 period

1. Group Coursework Submission Form
Specialist Masters Programme
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1. Okoh, Kwadwo
2.Wang, Ailing
3.Pei, Shu-Wei
4. Lemercier, Jean
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GROUP NUMBER:
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MSc in Finance
Module Code: SMM113
Module Title: International Finance
Lecturer: Ian Marsh Submission Date: 3/03/2014
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0

2. Year 2002 2003 2004 2005 2006
Average
Return
Standard
Deviation
1. Introduction
Currency carry trade is a well-known trading strategy used by investors to capture the difference in interest
rates between different countries. This report focuses on evaluating the performance of carry trade over 9
countries selected from G20 during 2002-2013. Both simple and portfolio approach have been examined,
which were carried out using Excel and Bloomberg respectively. Warning systems were also implemented to
avoid volatile trading period, thus reducing risk.
2. Data Selection
The data is split into two sections, Jan 2002-Dec 2006 and Jan 2007-Dec 2013. A split was created at the end of
2006 to study the effect of financial crisis and its influence on carry trade. The data has been collected on a
monthly basis and the carry trade is rebalanced every month. The analysis was carried out assuming domestic
currency is the USD, with an investment of $100,000 in each period. Countries used included France, Japan,
US, Australia, UK, Sweden, Switzerland, New Zealand and Norway. All the countries were selected from the
G20 because they have comparable economies, low risks of abnormal inflation and relatively low volatility in
exchange rate movements. As our carry trade is rebalanced on a monthly basis, one-month T-bills from each
country were used as the monthly interest rate. All the data was obtained either from DataStream or
Bloomberg.
3. Simple Carry Trade
The simple carry trade involves borrow from lowest interest rate currency and invest exchange proceeds into
highest interest rate currency. Each month, countries with highest and lowest interest rates were identified,
and their corresponding interest rates were used for carry trade calculation. The strategy assumes constant
exchange rate movements which is not true in reality. In our study, we have taken into account the currency
risk when calculating the returns. And the profit (loss) in each period is converted back to USD after debt
repayment. This process allows us to capture the true return in home country currency. For detailed
calculation example, please see Appendix 1. The annual returns from simple carry trade are summaries in
Table 1.
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%
Table 1. Simply carry trade annual return for periods 2002-2006 and 2007-2013
As shown in Table one, Period 1 (2006-2006) has much higher return and lower volatility than Period 2 (2007-
2013), which implies that the 2008 financial crisis had a large impact on the carry trade. Simply carry trade
exposed to very high risk when economy is unstable during crisis, with losses as large as -40% in 2008. As a
rational investor, we would like to control our risk. To improve our carry trade performance, a simple carry
with early warning sign implemented is then studied.
4. Implementing “warning signals” in the single pair carry trade
The main risk of the carry trade strategy lies in the possibility of the “carry” currency (currency with high
interest rates, ex. Australia) depreciating in value to the “funding” currency (currency with low interest rates, ex.
Japan). This can result in loses for the investor as he/she may need to repay a larger amount than what has
been gained on the interest rates differential. One of the ways to set a warning sign to detect possible
movements in exchange rates is to look at options’ implied volatilities. Implied volatilities are particularly
interesting because, unlike realised volatilities, they are forward looking: investors typically buy call/put options
when they believe the underlying’s value (the currency pair in this case) will significantly change over a given
period. In the context of the carry trade, it is safer to trade when implied volatilities are low (the market
1

3. does not believe there will be a large change in the currency pair value) and more risky when implied
volatilities are high (the market believes there will be a large change in the currency pair value).
The strategy for implementing the implied volatility used in this report is composed of two stages:
- Firstly, a benchmark is set in order to define an upper limit for implied volatilities above which the
carry trade is deemed too risky to be carried out and a lower limit under which the carry trade is seen
as relatively safe. This benchmark has been created using past data: the last five years monthly implied
volatilities of the currency pair. After calculating the average monthly implied volatility with this data,
an upper and lower bound = Mean ± 2*SDev have been defined.
- Secondly, the monthly implied volatilities over the carry trade period are compared to the limits
computed above. If the implied vol. for the month is greater than the upper limit, then there is no
carry trade for the month (Carry Trade*0). If the implied vol. is smaller than the lower limit, then the
carry trade is pursued using leverage 2:1 (Carry Trade*2).
5. Portfolio based carry trade
The portfolio based carry trade involves borrowing from a selected group of countries (the borrowing
portfolio) that have the lowest interest rates and lending to another group of countries (the investment
portfolio) that have the highest interest rates. In this case, we start by ranking the annualised monthly interest
rates at the beginning of each month. Then, we take the top three as our investment portfolio and the bottom
three as our borrowing portfolio. We borrow equal USD equivalent amounts from each country in the
borrowing portfolio, change these amounts to USD, and then invest equal USD equivalent amounts in each
country in the investment portfolio. At the end of the month, we realise our profit (loss) after paying back our
borrowings. Then, we rebalance the portfolio by ranking the interest rates again, selecting the borrowing and
investment portfolios and repeating the process of borrowing and investing.
6. Portfolio based carry trade with volatility signals
In the case, we use the similar strategy as before with regards to the ranking and portfolio selection, but we
use implied volatility signals to determine the weights of each currency as well as whether or not to invest in
each period. Initially, we obtain the implied volatility of each currency against the US dollar, and compare it to
pre-set benchmark. The benchmark we use for the period from 2002 to 2006 is based on 5 years average of
past volatility of each currency from 1996 to 2001. When the current implied volatility of each currency falls
two standard deviations above the benchmark, we do not trade that currency. However, when the current
implied volatility of each currency falls two standard deviations below the benchmark, we increase the weights
of that currency. When the current implied volatility of all the currencies in the borrowing or investment
portfolio fall two standard deviations above the benchmark, we invest all the funds in the risk free rate. On the
other hand, when the current implied volatility of all the currencies in the borrowing and/or investment
portfolio fall two standard deviations below the benchmark, we borrow equal amounts from each currency
and/or invest equal amounts in each currency
2

4. Portfolioannualreturn(%)
45.00%
35.00%
25.00%
15.00%
5.00%
-5.00%20 0 2 2 0 0 4 2 0 0 6 2 0 0 8 2 0 1 0 2 0 1 2
-15.00%
-25.00%
Year
-35.00%
Simple Carry Trade
AnnualCarryTradeReturn
-45.00%
Portfolio
Portfolio w signals
00 2002 2004 2006 2008 2010 2012 2014
Year
7. Results and analysis
40.00%
30.00%
20.00%
10.00%
0.00%
20
-10.00%
CarryTrade with Signal -20.00%
t
Figure 1-Pairwise and portfolio carry trade annual returns
Simple carry trade with and without signals :
The results clearly show that the single currency carry trade using signals by far outperformed the simple carry
trade without signals. The difference in performance is particularly significant during the 2008-2009 period,
where the implied volatilities are tremendous and as a result the signal carry trade is not actually trading. For
example in 2008 and with the beginning of the global financial crisis, the “carry” currency experiences a sharp
drop in value, the carry trade is down 40% but the carry trade with signals is only down 4.81%. However when
carry currencies start to recover in 2009 and the simple carry recovers (an impressive +41.78%), the carry trade
with signals is not trading because the implied option volatilities remain high (20%+ annual values). This is one
of the disadvantages of using at the money implied volatility: volatility both captures upward and downward
changes. As an investor in the carry trade, the main risk we want to avoid is downward changes in the value of
our carry currency: “upward” changes are beneficial to the value of our trade but the implied volatility does
not make this difference.
Portfolio carry trade with and without signals:
The results from 2002 to 2007 are highly correlated: the reason for this is that the low volatility over the period
does not impact the weights of the portfolio carry trade. Between 2007 and 2010, we observe very high
implied volatility on the currency pair and as a result the two carry trades diverge (-13.85% in 2008 against -
1.15% for the portfolio with signals). The portfolio carry trade without signals experiences tremendous
volatility in returns whereas the portfolio with signals is able to detect the high implied volatility and does not
trade as much. On the other side the portfolio carry trade with signals does not benefit from the upswing in
carry currency values post-crisis (+34.5% vs 0.08% in 2009) as the implied volatility remains quite high. After
2010 the correlation between the two portfolio increases as the implied volatility reduces.
In addition, the portfolio carry trade is better than the simple one on a risk management standpoint as the
maximum loss is significantly reduced especially during the 07 crisis. Even without the signal being
implemented, the portfolio carry trade experienced approximately only one third of the loss of the simple
carry trade in 2008 (-40% and -14% respectively). Furthermore, the portfolio carry trade still captured a high
return when the economy recovers.
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5. CumulativeWealth
$400,000.00
$350,000.00
$300,000.00
$250,000.00
$200,000.00
$150,000.00
$100,000.00
$50,000.00
$-
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 0.39
Risk 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%
Table 2. Performance measurements
Looking at the figures from table 2, one could think that the carry trade is an example of market inefficiency
since it seems to deliver abnormal returns: the risk adjusted return for the 02-13 period outperforms the US
equities benchmark, especially the portfolio carry trade with signals (19.07% as opposed to 7.82%). Only the
one pair carry trade without any signals does poorly compared to the US equities performance. The
conclusions are consistent with the previous yearly return analysis: the signals enable our portfolios to avoid
part of the tail risk and hence the standard deviation over the period is reduced (in particular for the simple
carry trade, a 7% change in standard deviation). For the portfolio carry trade, using signals does not reduce the
standard deviation of our investment as much as for the simple carry trade (a 3% reduction). This can be
explained by the fact that the portfolio carry trade’s returns are already less volatile than the simple one
(standard deviation of 9.08% vs 19.65%). It seems as though investing in multiple currencies allow for
diversification and improves the overall performance of our trades (the Sharpe ratios increase significantly).
US Market Return
Simple Carry Trade
Carry Trade with
Signal
Initial Investment
Portfolio
Portfolio with signal
2001
Figure 2-
Cumulative wealth (02-13) for an investment of $100,000
We can clearly see in figure 2 that the portfolio carry trades outperform on a return basis all the other
investments overall. The simple carry trade with signals delivered the greatest returns for the 2002 to 2007
period : the low implied volatility resulted in a two fold increase in the carry trade size (see Appendix 2),
magnifying returns over this period. After this period, the simple carry trade with signals remained more or less
flat as the implied volatility stayed at high levels. It is not the case for the portfolio carry trades with/without
signals as they earned consistent returns over the post crisis period.
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6. It is very important to note that the carry trades using signals did not experience large dips during the 07
period as the option implied volatility rose. In addition, three out of the four carry trades delivered a greater
wealth than the US equity market over the 12 years period. The carry trades all experience a small loss at the
end of the period, whereas the US equity market recovers.
8. Conclusion
Our analysis shows that carry trades have been profitable over the 2002 to 2013 period. The volatility in the
value of the carry currencies and the funding currencies remained very low over 2002-06 ; In addition carry
currencies on average appreciated to funding currencies, explaining the high returns. The second half of the
investment period (07-13) has seen extremely high losses for the carry trade (-40% for the simple carry trade,
and -13% for the portfolio carry trade). The start of the global financial crisis of 2007-2008 put a strong
pressure on carry currencies value as investors fled high risk areas for safer ones (US/Europe/Japan...). As a
result the interest differential on the carry was not large enough to cover the exchange rate losses (the
depreciation of the carry currency against the funding currency).
Nevertheless, the carry trades using signals have been able to reduce part of the crisis effect since the implied
currency pair volatility rose to record levels during this period. As a result, the risk adjusted returns and Sharpe
ratios both improved when using the warning signals. The carry trades with signals greatly outperformed the
US equity returns over this period, making it a rational investment option. However, here a few reasons why
the carry trade using signals may not consistently deliver such good results because of the particular risks
inherent to this strategy:
- The volatility captured by at the money options takes both possible upward changes & downward changes in
the value of the currency. As an investor in the carry trade, we are not concerned with upward change in value
(appreciation) of the carry currency but only in downward changes/depreciation to the funding currency.
- Implied volatility is only a measure of what the market believes the underlying’s volatility will be in the
future. There may be a large difference between the implied volatility and the actual realised volatility if the
markets incorrectly price volatility – therefore the warning signal used is indeed imperfect as it is only an
estimate. For example the simple and portfolio signals failed to detect some of the downward change of the
carry currency in 2008 (losses of -4.81% and -1% respectively over the year).
- The success of such a strategy heavily depends on the upper and lower bounds used and the sample used to
define these. For example using the past 10 years will give different results than using the past 5/2 years and
as a result the overall performance of the carry trade will be strongly impacted.
- Our model does not account for transaction costs and spread between the borrowing and lending rates.
Taking these into account will reduce the excess return of the carry trade for retail investors.
- The implied volatility signal has been efficient at measuring carry trade risk during the financial crisis. There is
no guarantee that this will be the case should another crisis/large currency move happen.
Different signals could be used for the carry trade. For instance the Delta risk reversal calculates the difference
in implied volatility between out of the money calls and out of the money puts. Using this signal would better
capture the volatility as it discriminates upward/downward volatility, making our carry trade more profitable
when the implied volatility on calls is high (investors believing that the carry currency will appreciate).
Given the ability to trade in international foreign exchange markets, investors should definitely invest in carry
trade with signal as it would provide diversification for the investor’s portfolio across different asset classes
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7. Reference
[1] French, Kenneth R. "Kenneth R. French - Description of Fama/French Factors." Kenneth R.
French - Description of Fama/French Factors. N.p., n.d. Web. 03 Mar. 2014.
<http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library/f-f_factors.html>.
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8. Appendix 1
Example of Simple Carry Trade Strategy
31/08/2009
France 0.282
Japan 0.140
US 0.099
Australia 3.150
UK 0.525
Sweden 0.408
Swiss 0.225
New Zealand 2.610
Norway 1.398
Country with highest interest rate Australia
3.150
Country with lowest interest rate US
0.099
Assumption : Initial borrowing equivalent to 100,000
USD
USD/JPY 94.838
AUD/JPY 92.949
NZD/JPY 63.810
NZD/USD 0.686
NZD/CHF 0.725
USD/USD 1.000
AUD/US 0.839
AUD/CHF 0.891
USD/CHF 1.057
US/EUR 0.701
AUD/EUR 0.588
Amount borrow from low interest
rate country
$ 100,000.00 a=100000*ER(US/US)
Amount invested in high
interest rate country
AUD
119,146.91
b=a/ER(AUD/US)
Interest received AUD 312.76 c=b*IR(AUD)/1200
Total received in invested currency AUD119,459.67 d=b+c
Amount to repay in borrowing
currency
$ 100,008.28 e=a*(1+IR(US)/1200)
Equivalent repayment in invested
currency
AUD
113,632.86
f=e/ER(AUD/US @
t+1)
Profit after repayment in invested
currency
AUD 5,826.81 g=d-f
Monthly profit convert back to USD $ 5,128.17 h=g*ER(AUD/US @
t+1)
Annual Return=Sum of monthly return / 100,000
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9. Appendix 2
Signal implementation
Historical Data
AUD/JPY implied
volatility
Actual AUD/JPY
implied volatility
31/12/1996 11.66 30/04/2002 9.7
(9.7<10.99)
Carry trade
increased by x2
31/01/1997 14.45 30/09/2002 11.85 Carry trade x1
... ... 31/08/2007 22.25
(22.25>18.34)
No carry trade x0
31/12/2001 12.43
Average 14.66
Sdeviation 1.83
Upper bound 18.34
Lower bound 10.99
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