Optimal carry trade portfolio choice under regime shifts

Abstract

This paper studies optimal currency allocation of the carry trade in foreign exchange (FX). A number of empirical studies have documented a phenomenon referred to as the ‘forward premium puzzle’, which states that the carry trade is profitable on average. However, the carry reversal during the 2008 global crisis periods wiped out the profits earned by the trade. To account for the regime shifts in the joint distribution of returns on the carry trade with FX market portfolios, we adopt a Markov regime switching model. We find evidence of two economic regimes: one state captures periods of the forward premium puzzle and UIP being violated, whilst the other reports high FX volatility and negative return of carry trade portfolio. Furthermore, to quantify the economic significance of regimes in returns on currency portfolios, we consider their importance in investors’ optimal portfolio allocation problem. We find strong evidence that optimal currency portfolio holdings vary significantly across regimes and across short and long investment horizons, as investors anticipate a shift out of the current state. Our results also show that the regimes partially anticipate peso events as well as the changes of funding liquidity measured by the TED spreads. A strategy that accounts for regimes, thus, generates overall stronger performance than the single-state Gaussian IID model, a carry trade procedure as well as a buy-and-hold strategy.