Tina Lindhqvist and Daniel Quach

Portfolio optimization with a carry trading strategy


Abstract

This study examines a portfolio allocation problem, where a carry trading
strategy is used, and currencies and interest rates are the assets
available. Carry trading is a zero-investment strategy that implies that
money is lent in a low interest rate-country, in order to be invested to
higher interest in another country.  In this way the interest rate
difference generates return to the investor, without any initial funds
being needed. We chose to model the exchange rates and interest rates with
a vector autoregressive model where the dynamic correlation between them
is captured. The portfolio allocation was first performed in the
single-period case and then extended to the multi-period case. The
optimization is based on the mean-variance theory developed by Markowitz
in the 1950Ős. The results from the investment strategy yields on average
a very high Shape ratio (the ratio between expected return and risk)
in-sample, but a low Sharpe ratio out-of-sample. Therefore the resultsŐ
reliability can be questioned, mainly due to the modelŐs simplicity and
the limitations of mean-variance theory.