Abstract
<p>Many attempts have been undertaken to solve the forward premium puzzle with little to no success. The global currency market is considered the most information efficient and transparent of all financial markets since it demonstrates a balance between over and under-reaction to information with remarkable consistency. The Efficient Market Hypothesis espouses investors cannot systematically outperform a benchmark since all investors have access to the same information. Therefore, the expected long-term rate of return for currencies is essentially zero. The Arbitrage Pricing Theory asserts investment returns are random. As such, traders cannot avail themselves of mispriced currencies. The assertion of Uncovered Interest Rate Parity is that bi-national interest rate variance is equal to the expected differential in exchange rates. This paper asks the following questions: does alpha persistence exist in currency carry trade funds or are its excess returns merely a collection of behavioral biases?</p>
Highlights
Risk is unequivocally linked to the behavioral trait of loss aversion; that is, investors are more conscious of losses than gains (Berkelaar, Kouwenberg, & Post, 2004)
If uncovered interest rate parity holds, the arbitrage opportunity in the NZD/JPY trading pair would be eliminated since the New Zealand Dollar return on NZD deposits will equal the NZD return on Japanese Yen
Whether an investor purchases available currency carry funds or buys currency pairs directly, the amount of profit generated will be limited due to high transaction costs further exacerbated by the constant rebalancing required to implement and maintain a momentum strategy
Summary
Risk is unequivocally linked to the behavioral trait of loss aversion; that is, investors are more conscious of losses than gains (Berkelaar, Kouwenberg, & Post, 2004). The following must be considered: Do currency carry trade funds manifest evidence of alpha or as Holmes (2009) posits, are these funds merely a collection of risky biases with associated downside risk? This overview contributes to the existing literature as it places the evidence in context and provides a survey of current literature and discussion of important theories It conducts, presents and reviews the results of an investigative study of two currency carry trade funds, the PowerShares G-10 Currency Harvest Fund Exchange Traded Fund and the iPath Optimized Currency Carry Exchange Traded Note, in an attempt to determine the existence of performance persistence present in either fund. The remainder of this paper is structured as follows: Section Two surveys the relevant literature; Section Three describes the data and provides descriptive statistics; Section Four presents a comparative analysis of the empirical results; and Section Five offers a summary and concluding remarks
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