Rule Based Investing: Designing Effective Quantitative Strategies for Foreign Exchange, Interest Rates, Emerging Markets, Equity Indices, and Volatility by Chiente Hsu

Author:Chiente Hsu [Hsu, Chiente]
Language: eng
Format: mobi
Publisher: Pearson Education
Published: 2013-12-17T00:00:00+00:00

Figure 2-1 Interest rates at historical low: Fed Fund Rate since March 1971 and one-month $ Libor Rate since December 1984

Figure 2-2 U.K. Bank of England Official Bank Rate since March 1911

“Benchmark” Returns in the FX Carry Trade

Given the ever-present exchange rate risk, what kind of returns should you expect an overall FX carry trade strategy to generate? Has the FX carry trade been profitable over the past decade? Certainly you seek a greater return than the risk-free rate on U.S. Treasuries; however, is the FX carry more or less attractive when compared with other risky investments such as investing in the stock market or the U.S. high yield bond market?

A benchmark currency carry investment is needed to illustrate in greater detail the profitability versus the risk of investing in the simplest form of the carry strategy. Let’s use the U.S. Dollar as the base currency against the nine most liquid foreign currencies (Australia Dollar, Canadian Dollar, Swiss Franc, Euro, British Pound, Japanese Yen, Norwegian Krone, New Zealand Dollar, and Swedish Krona). The rule is that on the monthly basis, you create an equally weighted basket such that if the interest rate of the foreign currency is higher than U.S. rate, you borrow one U.S. Dollar and buy and hold the foreign currency for a month. If the interest rate of the foreign currency is lower than U.S. rate, you borrow one U.S. dollar worth of foreign currency and buy and hold the U.S. dollar for a month. Note that these trades are always positive carry, where you net receive interest rates for holding the position. This investment is “net of funding” because the borrowing cost is taken into account. The return is therefore excess return.

This is a simple and inexpensive strategy to implement; Table 2-1 summarizes the resulting profitability of this buy-and-hold carry trade since January 2001. At first glance, the result is promising: over thirteen years, simple carry strategies, averaging among G10 currencies returned on the average 3.5% per year, with a Sharpe ratio of 0.31. This is higher than buy-and-hold in the S&P 500 over the same period, which returned 2.8% per year with a Sharpe ratio less than 0.18. Out of the nine currencies against the U.S. Dollar, seven achieved positive returns with the carry strategy, with Swedish Krona returns the highest at 8.59% per year.

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