Diversification Potential and Interest Rate Sensitivities of Currency Carry Trades

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Type and Duration

FFF-Förderprojekt, October 2015 until July 2018 (finished)

Coordinator

Chair in Business Administration, Banking and Financial Management

Main Research

Wealth Management

Field of Research

Banking and Finance

Description

With this research project, we want to innovate the perspective how to evaluate currency carry trades (henceforth called carry trade) and implement this enhanced perspective into the asset management process.
A currency carry trade tries to profit from the different interest rate levels in various currencies. The naïve currency carry trade is funded (invested) in a low (high) yield currency. The currency selection criterion of the funding and investment currency is the interest rate level of the two currencies. Naïve carry trades have a pre-defined, fixed amount of money to invest and fund. Additionally, naïve carry trades have a non-negligible crash and downside risk.
In a first part of this project we aim to reduce the risks of carry trades by introducing optimized carry trades. The main difference between naïve carry trades and optimized carry trades is, that optimized carry trades relax the restriction of fixed funding and investment.
In a second part we discuss the measurement of the market risk for naïve carry trades and optimized carry trades regarding interest rate shocks. Therefore, the second research method derives an approach, such that the impact of an isolated, single interest rate shock is observable. The target of this research objective is to identify the main risk drivers of carry trades, such that an investor can run a more sophisticated risk management.
The last part of this research project addresses the diversification effect of carry trades. Therefore, the last research objective will have the aim to shift the mean-variance frontier significantly. We will investigate the diversification effect by the statistical and economical significance.
The overall aim of this research project is to show the economical importance of this enhanced and innovative understanding of carry trades and, especially, the advantages of optimized currency carry trade portfolios in asset management.

Reference to Liechtenstein

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Keywords

Carry trade, Diversification, interest rate parity, sensitivity

Principal Investigator

Dr. rer. oec. Jurij-Andrei Reichenecker, MSc UZH ETH LL.M.

Project Collaborator

Prof. em. Dr. Marco J. Menichetti

Sponsor

  • Forschungsförderungsfonds der Universität Liechtenstein

Partner

  • VP Bank AG