Abstract
We construct a dynamic currency trading strategy that earns the (theoretically) maximum attainable Sharpe ratio. Empirically, our strategy earns a remarkable out-of-sample Sharpe ratio of 1.04 before and 0.78 after transaction costs. It substantially outperforms other popular carry trade strategies in terms of Sharpe ratio, skewness, kurtosis, maximum drawdown, expected recovery time, and percentage of positive returns. Popular factor pricing models in international finance do not explain the superior performance. Our strategy predicts future (1- to 24-month ahead) returns and changes in global volatility in FX markets. Moreover, a pricing model using our trading strategy as a single factor outperforms and fully replaces the popular dollar-carry two factor pricing model. The online appendix may be found at: http://ssrn.com/abstract=2837851.
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