Trading foreign exchange portfolios with volatility filters: the carry model revisited

Abstract

The rejection of the simple risk-neutral efficient market hypothesis in the foreign exchange (FX) market opens the possibility of the profitable use of a carry model taking full advantage of interest rate differentials to trade currencies. A first motivation for this paper is to study whether a simple passive carry model can outperform a typical currency fund manager replicated by dynamic technical moving average convergence and divergence (MACD) models as in Lequeux and Acar (1998). Secondly, we study whether the addition of volatility filters can further improve the carry model performance. We consider the period starting from the introduction of the Euro (EUR) on 4 January 1999 to 31 March 2005 (1620 datapoints). To assess the consistency of the carry model performance on a portfolio of the nine most heavily traded exchange rates, the whole review period is further split into two sub-periods. Our results show that in the three periods considered and after inclusion of transaction costs, the simple carry model performs much better than the benchmark MACD model in terms of annualized return, risk-adjusted return and maximum potential loss, while a combined carry/MACD model has the lowest trading volatility. Moreover, the addition of two volatility filters adds significant value to the performance of the three models studied.