Carry trade optimization

Abstract

This thesis investigates various possible improvements of implementing the carry trade. For this purpose a number of benchmark carry trade strategies are formed to which the results of the modified strategies are compared. The modified carry strategies take the correlations and/or volatilities of the currencies into account, aiming for a more efficient portfolio in the return to risk sense. Specifically, the effects of optimizing the carry strategy using a covariance matrix estimated with the intrinsic currency valuation framework is investigated. This is compared both with the benchmark carry strategies and the carry strategy optimized using an ordinary covariance matrix. I find that the carry strategy can be improved with portfolio optimization techniques. Both the information ratio of the strategy, as well as the skewness and kurtosis benefits from diversifying the trade across several currencies. However, the choice of which covariance matrix to use in the optimization is not important.