Abstract:   The last decade currency carry trade has gained a lot of popularity because of their apparent profitability. It is a strategy that has been developed to exploit violations of the Uncovered Interest Rate Parity. In particular, an investor must take a short position in a low-yielding currency to fund a long position in a high-yielding currency. In this research, we tried to contribute in the previous literature for the currency carry trade and its characteristics by using a different approach. Most of the researches that have been conducted in this area concern the risk agents associated with this strategy. However, in our research we investigated the relationship between currency carry trade and two equity indexes, one from the European market (DAX) and one from the American (DJIA). In order to do that, we estimated the returns of the DAX and the Dow Jones Industrial Average (DJIA) as well as the returns of a carry trade index created by the Deutsche Bank, the Deutsche Bank’s G10 Currency Future Harvest index. The returns were estimated for a time period of twenty years (1995-2014). More specific, we examined whether there is granger causality between the returns of carry trade and of DAX/DJIA, whether there is leverage effect on the returns of the same index and finally whether changes in the returns of one of those indexes can affect the subsequent volatility of the other two. For being able to do this examination, we used two different statistical models, the Vector Autoregression (VAR) and the EGARCH [1, 1] model.       The first empirical finding suggests that there is granger causal effect from the two equity markets to carry trade, however the carry trade granger cause only to DJIA index. The second finding indicates that there no leverage effect form the past returns to the future volatility for all the three indexes. Finally, the last finding suggests that the volatility process on the returns of one index cannot be determined by changes in the returns of the other two indexes. Keywords: Currency carry, uncovered interest rate parity, DAX, DJIA, G10 currency, granger causality, VAR, EGARCH[1,1]

The currency carry trade – whereby one simultaneously borrows in a currency with low interest rate and invests in a currency with high interest rate – is estimated to be at least USD 2.0 trillion in emerging markets alone. By some characterised as “picking up nickels in front of a steam roller”, the carry trade is subject to pronounced periods of disadvantageous currency depreciations. Although the carry trade has been profitable historically, these sudden depreciations at least attenuate, if not completely eradicate returns. The search for yield has led contemporary investors to emerging markets where the volatility is higher, thereby increasing risk and prospective return. The purpose of this thesis is to investigate how quantitative risk indicators can be constructed in order to detect market-reversals, mitigate currency depreciations, and ultimately improve the profitability of the emerging market currency carry trade. For this purpose risk has been categorised into two dichotomous risk classes, global and idiosyncratic; the former referring to systematic, non-country specific risk; the latter to residual, country specific risk. Each risk has been modelled separately. By optimising carry trade return conditioned on a number of distinctive risk measures, attributable to the respective risks, it was concluded that a broad weighted global risk indicator provide substantially augmented risk-adjusted return in an emerging market carry trade, while idiosyncratic indicators might require a bespoke framework for each currency at hand. / Valuta carry-handeln (carry trade) – vari en investerare lånar i en valuta med låga räntor och investerar i en valuta med höga räntor – beräknas omfatta åtminstone två biljoner USD enbart i tillväxtmarknader. Karakteriserat av vissa som att ”plocka upp kronor framför en ångvält” [författarnas översättning], är carry-handeln utsatt för tydliga perioder av ogynnsamma valutadeprecieringar. Trots carry-handelns historiska lönsamhet, dämpar, om inte helt raderar, dessa nedgångar avkastningen. Sökandet efter avkastning har fått investerare att alltmer vända sig till tillväxtmarknader, där volatiliteten är högre och därmed risken samt den förväntade avkastningen. Syftet med denna uppsats är att utforska hur kvantitativa riskindikatorer kan konstrueras för att förekomma marknadsvändningar, dämpa effekten av valutadeprecieringar, och slutligen stärka carry-handels lönsamheten i tillväxtmarknader. I detta syfte har risk kategoriserats i två tudelade riskklasser, global och idiosynkratisk; den förra hänsyftar systematisk, icke-landspecifik risk; den senare osystematisk, landspecifik risk. Vardera risken har modellerats separat. Genom att optimera carry-handelns avkastning villkorat under ett antal distinkta riskmått hänförbara till respektive risk, drogs slutsatsen att en bred, viktad, global riskindikator gav carry-handeln i tillväxtmarknader väsentligt förbättrad riskjusterad avkastning, medan idiosynkratiska riskindikatorer kräver speciellt anpassat tillvägagångssätt för vardera valutan.

Currency carry trade is an investment strategy that recently started gaining a lot of interest not only among investors and financial institutions but also academically. One of the underlying theoretical assumptions regarding the mechanisms of the foreign exchange market, the Uncovered Interest Parity has frequently been disproved in practice which has led to the conclusion that carry trade is profitable in practice. The function of a carry trade strategy is that a short position is taken in a low interest rate currency to finance a long position in another currency offering higher yields. This thesis is adding to the existing literature that is explaining the characteristics of currency carry trade but is adopting a different approach than most other recent researches that has focused on identifying especially risk factors. Gold as a financial asset has also received much attention largely due to its, contrarily to other asset classes, low dependence on macroeconomic factors. This makes gold desirable to diversify portfolios and decreasing overall risks. By investigating how the returns of currency carry trades and gold relates to each other an increased understanding in how carry trades can be beneficially included in managing portfolios are developed. Looking at a currency carry trade index, Deutsche Bank’s G10 Currency Future Harvest index, and the development of the gold price at the London bullion market for the 20 year period of 1993-2013 this research is exploring correlation, mean and volatility spillover effects. Spearman’s correlation, Vector Autoregression and a diagonal BEKK GARCH model are employed to test these effects. It also investigates if gold possesses hedge, diversifier and safe haven characteristics when combined with carry trades as it has been found to do with stock markets. This is determined by a regression analysis and supplemented by a portfolio simulation. This thesis found that there is a low positive correlation between the returns of gold and currency carry trades and that there is spillover effects as well between the two in both returns and volatility. This in addition to the regression analysis and portfolio analysis determined that there are diversification benefits by adding gold to a portfolio consisting of currency carry trade in the form of higher risk adjusted returns. However special caution has to be taken to the spillover effects as these complicate the relationship between the returns of the two variables and especially the volatility spillover effects slightly decreases the potential diversification benefit. The regression analysis concluded that gold work as a diversifier for carry trade but could not determine if it also exhibited hedge or safe haven characteristics. These findings pushes the existing understanding of carry trades forward and adds to focus of matching carry trades within a portfolio which could have implications to more efficiently match risks and returns by combining several asset classes in portfolio management.