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# CARRY TRADE: THE GAINS OF DIVERSIFICATION

Craig Burnside

Duke University

Sergio Rebelo

Northwestern University

Martin Eichenbaum

Northwestern University

Abstract Market participants routinely take advantage of the failure of uncovered interest rate parity to speculate in currency markets. Perhaps the most widely used currency speculation strategy is the carry trade. In this article we take the perspective of an individual currency trader and document the gains to diversifying the carry trade across different currencies. We show that these gains are large. Diversiﬁcation boosts the typical Sharpe ratio by over 50%.

1. Introduction It is well-known that uncovered interest rate parity (UIP) does not hold.1 UIP implies that high interest rate currencies should depreciate vis-à-vis low interest rate currencies. In fact, on average, they appreciate. Market participants routinely take advantage of the failure of UIP to speculate in currency markets. Perhaps the most widely used currency speculation strategy is the carry trade. This strategy involves selling forward currencies that are at a forward premium (i.e., the forward rate exceeds the spot exchange rate) and buying forward currencies that are at a forward discount. Transactions costs aside, this strategy is equivalent to borrowing low interest rate currencies, lending high interest rate currencies, and not hedging exchange rate risk. In practice one can apply the carry trade to individual currencies or to portfolios of currencies. Burnside et al. (2006) consider the payoff to an equally weighted portfolio of carry-trade strategies. This portfolio of strategies is constructed as follows. In every period the investor places an identical dollar bet in

Acknowledgments: Burnside is grateful to the National Science Foundation for ﬁnancial support (SES-0516697). The authors are members of the NBER. E-mail addresses: Burnside: burnside@econ.duke.edu; Eichenbaum: eich@northwestern.edu; Rebelo: s-rebelo@kellogg.northwestern.edu 1. See Bilson (1981) and Fama (1984) for early empirical work documenting the failure of UIP. See Hodrick (1987) and Engel (1996) for surveys of the literature.

Journal of the European Economic Association April–May 2008 © 2008 by the European Economic Association

6(2–3):581–588

” Our article is organized as follows. Section 4 contains concluding remarks. Ireland. Netherlands. The ask (bid) exchange rate is the rate at which a participant in the interdealer market can buy (sell) U. 3. Austria. In this article we take the perspective of an individual currency trader and document the gains to diversifying the carry trade across different currencies. We incorporate currencies into our analysis as data on them become available. Italy. Greece. at least in our sample.582 Journal of the European Economic Association all the currencies. selling forward those that are at a premium and buying forward those that are at a discount. Perhaps more importantly. Norway.K. Canada. We show that these gains are large.S. Portugal. Three Carry-trade Strategies We consider a version of the carry-trade strategy that takes into account bidask spreads both in the design of the trading strategy and in the computation of payoffs. France. Belgium. We construct a monthly data set by sampling daily data on the last day of each month. Let Fta and Ftb denote the ask and bid forward exchange rate. Sweden. the payoffs of the strategy are uncorrelated with traditional risks factors. South Africa. dollars from a currency dealer. In Section 2 we describe the data used in our analysis. show that the Sharpe ratio generated by this strategy is positive and statistically different from zero. Our sample also includes the Euro after 1999. Data Our data are from Datastream and cover the period from January 1976 to June 2007. Denmark. Burnside et al. Singapore. 2. But. So the payoff to the carry trade cannot be interpreted as compensation for bearing risk. for . Germany. Spain. respectively. To assess the robustness of our results we report results for both the full sample and the post-Euro period (January 1999 to June 2007). In this sense our results give lie to traders’ aphorism that “when markets go down. and the U. respectively. New Zealand. Of course. it is possible that a large low-probability shock could drive all payoffs down together and negate the gains from diversiﬁcation. There are 23 countries in our sample: Australia. Our data include both bid and ask exchange rates. dollar. This large rise in the Sharpe ratio reﬂects the imperfect correlation between carry-trade payoffs for different currencies. such a shock did not occur.S. Each exchange rate is quoted as foreign currency units per U. Switzerland. Diversiﬁcation boosts the typical Sharpe ratio by over 50%. the only thing that goes up is correlation. Japan. Hong Kong. In Section 3 we discuss three carry-trade strategies and present our results. Finland. Let Sta and Stb denote the ask and bid spot exchange rates.

55 for the post-Euro sample. We normalize the total size of the bet to one dollar. there are large gains from diversifying the carry trade across different currencies. the annualized median Sharpe ratio across currency-speciﬁc carry trades is 0. the annualized average Sharpe ratio for the high-low carry-trade strategy is 0. The carry trade is a zero net investment strategy. In the “currency-speciﬁc carry-trade” strategy we apply equation (1) to an individual currency. 0 if xt = 0. 2. b (2) zt+1 = xt Fta /St+1 − 1 if xt < 0. At each point in time we sell the U. The Sharpe ratio is positive and statistically different from zero for both samples. dollar. On an annualized basis the Sharpe ratio is 0.83 for the whole sample and 1. All exchange rates are expressed as foreign currency units per U.23 for the post-Euro sample. dollar forward against the currency that has the smallest value of Fta/Stb . In these cases we double the size of the bet on the currency that has the highest forward premium. Finally. and Sharpe ratio associated with the excess returns to our three strategies. xt = −1 if Fta /Stb < 1. In the “high-low carry-trade” strategy we take a position only in the two currencies with the highest forward premium and discount. (1) 0 otherwise. dollar.S.Burnside. Table 1 reports the mean. Eichenbaum. We sell xt dollars forward according to the rule: +1 if Ftb /Sta > 1. Consider ﬁrst the results for the equally weighted carry-trade strategy. standard deviation. Relative to the high-low carry trade.2 If 1/Sta and 1/Stb are martingales.S. and Rebelo Carry Trade: the Gains of Diversiﬁcation 583 forward contracts maturing at time t + 1. . In contrast. in equation (1) we normalize the size of the bet to one.54 for the post-Euro sample.S. The realized payoffs are given by: a xt Ftb /St+1 − 1 if xt > 0. normalizing the size of the bet to one dollar. We consider three strategies.S. dollar forward against the currency that has the highest value of Ftb/Sta and we buy the U. this strategy corresponds to buying and selling the two forward contracts with the highest expected payoffs.50 for the whole sample and 0.54 for the whole sample and 0. In the “equally weighted carry-trade” strategy the dollar position gives equal weight at each point in time to all the currencies for which we have data and for which xt is different from zero. There are instances in our sample in which there are no currencies at a forward discount against the U. the rise in the Sharpe ratio associated with the equally weighted carry trade is mostly due to a 34% decline in volatility. Clearly.

267) 0. Japanese yen available from 1978M7.054 (0.028) 0.671) 1.505 (0.009) 0.030) 0.053 (0.013) 0.422 (0.093 (0.025 (0.004) 0. Euro Equally weighted portfolio High-low portfolio 0.034) 0.042) 1999M1–2007M6 Standard Deviation 0.171 (0.006) 0.108 (0.058 (0.009) 0.032) 0.001) 2.006) 0.205) −0.003) 0.943 (0.006 (0.044 (0.013 (0.015) 0.114 (0.236 (0. Irish punt available from 1979M4.048) 0.071 (0. Austrailian dollar.054 (0.007) 0.510) 0.094 (0.285 (0.017) 0.193) Mean 0.014 (0.368) 1.313 (0.006) 0.258) 0. Standard errors in parentheses.071 (0.038 (0.297) 0.074) 0.065) 0.006) 0.102 (0.008) 0.096 (0.114 (0.882 (0.086 (0.979 (0.990 (0.017 (0.016) 0.037) 0.034) 0.044) 0.024) 0.087 (0.054) 0.008) 0.864 (0.307) 0.008 (0.362) 1.294) 0.030) 0.007) 0.241) 0.098 (0.249 (0.113 (0.010) 0.109 (0.979 (0.224) 0.121 (0.031) 0.031) 0.007) Sharpe Ratio 1.060 (0.030) 0.002) 0.111 (0. and South African rand available from 1997M1.238 (0.017 (0.340) 0.156 (0.273) 0.109 (0.085 (0.006) 0.383) Notes: Euro legacy currencies until 1998M12.109 (0.K.102 (0.260) 0.103 (0.584 Journal of the European Economic Association Table 1.828 (0. New Zealand dollar.002) 0.011 (0. 1976M1–2007M6 Mean Australia Austria Belgium Canada Denmark Finland France Germany Greece Hong Kong Ireland Italy Japan Netherlands New Zealand Norway Portugal Singapore South Africa Spain Sweden Switzerland U.007) 0.362) 0.097 (0.060 (0.244) 0.005) 0. .032) 0.056 (0.320 (0.026 (0.450) 0.006) Sharpe Ratio 1.009) 0.376) 0.025) 0.120 (0.024 (0.013 (0.679) 0.165 (0.084 (0.115 (0.017) Standard Deviation 0.034 (0.367 (0.020) 0.031) 0.296 (0.031) 0. the equally weighted portfolio.314) 0.523 (0.951 (0.240) 0.427 (0. Excess returns to the carry-trade strategies (statistics presented on an annualized basis).025 (0.038 (0.034) 0. Greek drachma.006) 0.006) 0.028) 0.120 (0.350) 0.492 (0.060) 0. Finnish markka.042 (0.020) −0.372) 0.144 (0.052 (0.032) 0.041) 0.091 (0.006) 0.562 (0.067 (0.116 (0.035 (0.036) 0.539 (0.007) 0.009) 0.004) 0.088 (0.078 (0.150 (0.102 (0.210 (0.011 (0.393) 0.259) 0.230 (0.099 (0.049 (0.111 (0.084 (0.016) 0.627 (0.006) 0.065 (0.357) 0.055 (0.006) 0.475) 0.209) 0.008) 0.095 (0.088 (0.008) 0.038 (0.091 (0.113 (0.562 (0.003) 0.007) 0.111 (0.233 (0.219) 0.011 (0.551) 0.310) 0.176 (0. All other currencies.029) 0.541 (0.028 (0.465) 0.213) 0.538 (0.553 (0.040 (0.017) 0.024) 0.013) 0.003) 0.428) 0.084 (0. Singapore dollar.009) 0.085 (0.236) 0. Hong Kong dollar.009) 0.007) 0.014) 0.552 (0.044 (0.320) 0.160 (0.043 (0.399) 0.004 (0.001) 0.007) 0.132 (0.184 (0.347) 0.037) 0.076 (0. and the high-low portfolio are available for 1976M1–2007M6.025) 0.108 (0.922 (0.

Eichenbaum. Realized Sharpe ratios of currency portfolios. Indeed. Panel a of Figure 1 displays a 36-month rolling window of the annualized Sharpe ratios associated with these strategies. Comparing the rolling Sharpe ratios we see that the one associated with the equally weighted carry trade is substantially less volatile than the one associated with the high-low strategy. the rolling Sharpe ratio for the equally weighted carry-trade strategy has not been negative since the mid-1990s. Also note that there are very few periods in which the equally weighted carry trade has a negative rolling Sharpe ratio. Annualized.Burnside. and Rebelo Carry Trade: the Gains of Diversiﬁcation 585 Figure 1. In contrast. the rolling Sharpe ratios for the equally weighted carry-trade strategy have been uniformly positive and large for most of the post-2000 period. the rolling Sharpe ratio associated . Consistent with the attention that the carry trade has received in the ﬁnancial press. 36-month rolling window.

S. stock market.16) and signiﬁcantly different from zero. Table 1 indicates that. The skewness of the excess returns to the value-weighted U. Clearly the payoffs associated with the New Zealand carry trade are very volatile and were negative for an extended period of time. over the whole sample. Panel b of Figure 1 illustrates this fact vividly for two currencies that have received much attention in the ﬁnancial press as being widely used in carry-trade strategies. the payoffs to the equally weighted carry trade are less skewed than the payoffs of the other strategies. For all three carry-trade strategies we can reject the hypothesis that the distribution of payoffs is normally distributed. for the post-Euro period the Japan’s Sharpe ratio is not statistically different from zero. Perhaps more signiﬁcantly. This difference is particularly pronounced in the case of the high-low carry-trade strategy. However. Relative to the currency-speciﬁc carry trade.78 for the whole sample and −0. they are consistently negative from 2003 to 2006.” This characterization seems appropriate for the currencyspeciﬁc and the high-low carry-trade strategies: The payoffs have low means and exhibit fat tails. and the currency-speciﬁc carry-trade strategies. the large rise in the Sharpe ratio associated with the equally weighted carry trade is due to a 52% fall in the standard deviation of the payoffs.72 for the post-Euro sample (see Table 3). Japan’s Sharpe ratio for Japan is large (0. the skewness of the payoffs to the equally weighted carrytrade strategy is −0. the payoffs to this carry-trade strategy are less skewed than those of the value-weighted excess return to the U. over the whole sample period. the rolling Sharpe ratios associated with the equally weighted portfolios and those associated with the New Zealand and Japan carry-trade strategies. stock market is −0. 4. Notice that the rolling Sharpe ratios for New Zealand are uniformly negative from 1999 to 2001. for the post-Euro period.586 Journal of the European Economic Association with the high-low strategy is consistently negative from the late 1990s to roughly 2003.S. In fact. this characterization is not appropriate for the equally weighted carry-trade strategy. However. But it is clear that. This last result is illustrated by panel b of Figure 1. This table reports the skewness and kurtosis associated with the equally weighted. This panel displays. Conclusion The carry-trade strategy is sometimes dismissed as involving “picking up pennies in front of a truck. 3. The rolling Sharpe ratios associated with the Japan carry trade are not very large on average. the high-low.3 In contrast.17 both for the whole sample and the post-Euro sample. Table 2 provides a different perspective on the gains from diversiﬁcation. We computed these estimates using data obtained from the Fama–French research database. .

Irish punt available from 1979M4.576 (0.179) −0.234) 0.086 (0.0 (0. 1976M1–2007M6 Skewness Australia Austria Belgium Canada Denmark Finland France Germany Greece Hong Kong Ireland Italy Japan Netherlands New Zealand Norway Portugal Singapore South Africa Spain Sweden Switzerland U. Greek drachma.256) −0. .403) 0.7 (0.154) −0.200 (0.725 (0.180) −0.694) 0.366 (0.186) −0.232) −0.330 (0.962 (0.000) 3.445) −0.085) 6.088 (0.475) 16. Euro Equally weighted portfolio High-low Portfolio −0.280 (0.200) −0.442 (2.169 (0.183) −0. Austrailian dollar.437) 0.576 (0.925) 4.145) −0.535) 2.417) 313.358) −0.189) 0.173 (0.363 (0.079 (0. Singapore dollar.581) 1. Eichenbaum.530 (0.0 (0.5 (0.005 (0.938 (0.966) 0.003) 44.529 (0.4 (0.039 (0.373) Jarque-Bera Statistic 1.358) −0.166 (0.4 (0.518) 3.306) 1.078 (0.3 (0.242) −0.1 (0.405) 1.516) 1.952 (1. and Rebelo Carry Trade: the Gains of Diversiﬁcation 587 Table 2.8 (0.774 (0.533 (0.1 (0.6 (0.2 (0.285) 18.288) −0.261 (0.545) 2.062 (0.169 (0.035 (1.8 (0.1 (0.5 (0.286) Excess Kurtosis −0.294 (0.000) 125.535) 0.872 (0.591 (0. and South African rand available from 1997M1. and the high-low portfolio are available for 1976M1–2007M6.181) −0.427) 0.075) >1000 (0.6 (0.025) 4.548) 1.307) 0. New Zealand dollar.776 (0.000) 1.352) 1.000) 179.136) 0.454) −0.000) 209.242) −0.217 (1.360) 0.223) −0.442) 6.753) Jarque-Bera Statistic 1.694) 4.933 (0.215) 0.321 (0.476 (0.239) 1999M1–2007M6 Excess Kurtosis −0.687) 3. Finnish markka.050) 5.059) 0.417) 1.498 (0. All other currencies.120 (0.000) 25.8 (0.2 (0.218) 0.108 (0.162) −0.013 (0.1 (0.153 (0.176) 3.9 (0.8 (0.422) 3.454) 1.294 (0.274 (0.451 (0.612 (0.315) −0.244) −0.221) 1.7 (0.143) −0.6 (0.589 (0.386) −0.405) −0.283) 1.721) −0.000) 0.275) 98.942) 5.633) 188.179 (0.492) 0.019 (0. Japanese yen available from 1978M7.3 (0.316 (0.000) −0.401 (0.294 (0.205) 0.054 (0.K.341) −0.023 (0.452 (1. Hong Kong dollar.083 (0.2 (0.574 (0.479) 19.439) −0.000) 2.208) −0.436) 7.178 (0.157 (0.474) 0.245 (0. Higher moments of the excess returns to the carry-trade strategies.196) −0.645) 1.7 (0.080 (0.0 (0. p-value for the Jarque-Bera statistic.535 (0.9 (0.182) −0.377) 0.357) 0.314 (0.382) −0.241) −0.374) Note: Euro legacy currencies until 1998M12.931 (0.248 (0.9 (0.405 (0.225) −0.532) 2.433) 2.340 (0.833) 1.349 (0.130 (5.158) −0.437) −0.051 (0.125 (0.364) 0.0 (0.485 (0.333) 0.877) 2.235) −0.6 (0.324 (0.619 (1.6 (0.452) −0.2 (0.319 (0.000) Skewness −0.7 (0. the equally weighted portfolio.4 (0.130 (0.335) 0.207) 0.1 (0.121) 25.482) 3.514) −0.000) 11.802 (0.077 (0.762) 0.460 (0.000) 0.200) −0.000) 80.921) 4.5 (0.258) 0.3 (0.207 (0. Standard errors in parentheses for skewness and kurtosis.2 (0.025) 0.720 (0.Burnside.085 (0.6 (0.

073 (0.149 (0. Martin Eichenbaum.570) Jarque-Bera Statistic 155.322) Higher moments of the excess return to the value-weighted U. 319–338.588 Journal of the European Economic Association Table 3. (1987). except for the Jarque-Bera statistic. It is much less obvious what particular peso problem can explain the high Sharpe ratio associated with the equally weighted carry trade. to date. Isaac Kleshchelski.18 for the post-Euro sample) reﬂects political risk associated with mainland China that.777 (0.350) Excess Kurtosis 2. Eugene F.8 (0.7 (0. “Forward and Spot Exchange Rates. Engel.184) Mean 0. Craig. Burnside. It is always possible that the positive returns to the carry trade reﬂect a peso problem.249) 1999M1–2007M6 Excess Kurtosis 0. Fama. 14.009) Sharpe Ratio 0. it is almost surely the case that the high Sharpe ratio associated with the Hong-Kong dollar carry trade (2. Harwood Academic.S. “The Returns to Currency Speculation.156 (0. O.737 (0. That strategy seems to involve “picking up pennies in front of an unknown truck that has never been seen.” References Bilson.001) Notes: Standard errors in parentheses. Excess returns to the value-weighted U. 435–451.418 (0. . The Empirical Evidence on the Efﬁciency of Forward and Futures Foreign Exchange Markets.015) Sharpe Ratio 0. “The ‘Speculative Efﬁciency’ Hypothesis. for which the p-value is shown. Indeed.909) Jarque-Bera Statistic 13. 123–192. stock Market.047) 1999M1–2007M6 Standard Deviation 0. John F.S.” National Bureau of Economic Research Working Paper No.” Journal of Empirical Finance 3.000) Skewness −0. Charles (1996). Hodrick. Robert J. 54. (1984). stock market (statistics presented on an annualized basis). “The Forward Discount Anomaly and the Risk Premium: A Survey of Recent Evidence.488 (0.” Journal of Business.” Journal of Monetary Economics. 12489.025) Standard Deviation 0. has not materialized. and Sergio Rebelo (2006). (1981).724 (0. 1976M1–2007M6 Skewness –0.738 (1.065 (0. 1976M1–2007M6 Mean 0.