From carry trades to curvy trades

Abstract

Traditional carry trade strategies are based on differences in short‐term interest rates, neglecting any other information embedded in yield curves. We derive return distributions of currency portfolios, where the signals to buy and sell currencies are based on summary measures of the yield curve. We find that a strategy based on the relative curvature factor, the curvy trade, yields higher Sharpe ratios and a smaller return skewness than traditional carry strategies. Curvy trades build less upon the typical carry currencies and are hence less susceptible to crash risk. In line with that, standard pricing factors of traditional carry returns fail to explain curvy trade returns.

Yield curve risks in currency carry forwards

“…The structure of key variables of the previous relative Nelson–Siegel model in Chen and Tsang (2013), Berge et al (2010), Dreher et al (2018) and Gräb and Kostka (2018) is the difference in cross‐country factors between a funding currency and an investment currency underlying the assumption of the identical factor loading over all countries. However, based on this simple factor difference, it is hard to apply the relative model to currency portfolio investments because the relative model regards that country‐specific factor loadings are not critical information in understanding carry trades.…”

“…Furthermore, Berge, Jordà, and Taylor (2010), Tsang (2013), andGräb, and extend the basic carry trade strategies with relative Nelson and Siegel factors. 2 Also, Dreher, Gräb, & Kostka, (2018) investigate which of the three relative Nelson-Siegel factors provides the strongest signal for future exchange rate dynamics while controlling for several pricing factors of carry returns, such as exchange rate volatility, liquidity, and momentum. They find that the relative level, slope, and curvature factors are predictive to describe the anomaly in reflecting market expectation of future fundamentals.…”

“…To cope with the little explicability of the interest rate differentials and reflect economic fundamentals, several studies have exploited the term structure of yields to investigate the forward premium anomaly in that the term structure of yields is associated with future interest rates (Cochrane & Piazzesi, 2005;Estrella & Hardouvelis, 1991;Piazzesi & Swanson, 2008). Furthermore, Berge, Jordà, and Taylor (2010), Tsang (2013), andGräb, and extend the basic carry trade strategies with relative Nelson and Siegel factors. 2 Also, Dreher, Gräb, & Kostka, (2018) investigate which of the three relative Nelson-Siegel factors provides the strongest signal for future exchange rate dynamics while controlling for several pricing factors of carry returns, such as exchange rate volatility, liquidity, and momentum.…”

“…Using three yield curve components (i.e., level, slope, and curvature) of the Nelson and Siegel's term structure model (Nelson & Siegel, 1987) to proxy for future market fundamentals, Chen and Tsang (2013) originally developed the relative Nelson-Siegel factors. Berge et al (2010) and Dreher et al (2018) and Gräb and Kostka (2018) have followed and employed the relative Nelson and Siegel factors to examine their applicability in currency carry trades. 3 The previous literature sets to 0.0609 following .…”