NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Joseph B. Doyle

Cornerstone Research
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NBER Working Papers and Publications

December 2012Carry Trade and Systemic Risk: Why are FX Options so Cheap?
with Ricardo J. Caballero: w18644
In this paper we document first that, in contrast with their widely perceived excess returns, popular carry trade strategies yield low systemic-risk-adjusted returns. In particular, we show that carry trade returns are highly correlated with the return of a VIX rolldown strategy --i.e., the strategy of shorting VIX futures and rolling down its term structure-- and that the latter strategy performs at least as well as beta-adjusted carry trades, for individual currencies and diversified portfolios. In contrast, hedging the carry with exchange rate options produces large returns that are not a compensation for systemic risk. We show that this result stems from the fact that the corresponding portfolio of exchange rate options provides a cheap form of systemic insurance.
 
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