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The new new carry trade in the age of derivatives

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Investors have made money for decades by borrowing in one currency with a low interest rate and exchanging it into a higher interest rate currency.  Called the carry trade, it made a lot of people of lot of money.

A new paper out by Della Corte, Sarno and Tsiakas has found another way to profit off the carry trade.  These economists use the forward volatility in foreign exchange to derive a very profitable strategy.  According to their research, Spot and Forward Volatility in Foreign Exchange, investors can buy and sell what’s called a forward volatility agreement (FVA).

Simply put (kinda), thes FVAs attempt to predict future volatility in a certain currency.  More specifically, the FVA sets a forward implied volatility by making a guess about future spot implied volatility.  These guesses tend to be wildly off:

Forward volatility is a poor predictor of future spot implied volatility

So, if forward vol is a bad predictor of future vol, investors can design strategies to take advantages of this.

For example, buying (selling) FVAs when forward implied volatility is lower (higher) than current spot implied volatility will consistently generate excess returns over time.

Interesting idea — as for me, I’ll stick with momo stocks like $AAPL and $PCLN but this sounds like a promising strategy for forex traders.

Source

Della Corte, P, L Sarno, and I Tsiakas (2010), “Spot and Forward Volatility in Foreign Exchange”, Journal of Financial Economics, forthcoming. Centre for Economic Policy Research Discussion Paper 7893.

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