Working Papers

Empirical evidence shows that FX fundamental models have produced disappointing results over the past 20 years while carry trade strategies have performed superbly. But the real picture is much more complex.
In fact, the track records of both strategies have varied considerably. This article shows that they have actually alternated between periods of profitability and underperformance. It also shows that when carry trade strategies perform well, fundamental strategies do poorly, and vice versa. Crises appear to play a significant role in the alternation of investment styles on currency markets. In contrast to carry trades, fundamental strategies perform remarkably well in crises. A portfolio that rotates between these two types of strategies, based on a risk aversion indicator such as implied equity volatility, would substantially outperform a pure carry trade strategy.

Direct exposure to volatility has been made easier, for a wide range of underlyings, by the creation of standardized instruments. The widespread use and increasing liquidity of volatility index futures and variance swaps clearly show that investors are taking a keen interest in volatility. In addition to shortterm trading ideas, some investors now look for a structural exposure to volatility as they consider it either as a well identified asset class or, at the very least, a set of strategies with strong diversifying potential for their portfolios.
The scope of this paper is therefore to construct an analytical framework useful for investors willing to assess the benefits of a long-term investment in volatility…

A financial crisis is typically associated with a rise in the volatility of most assets. Moreover, if the crisis is “contagious”, things become even worse for investors because correlations among asset returns also increase and diversification becomes less efficient than during quiet periods. As most identified financial crises have been positively tested for contagion (Loretan and English (2000), Hartmann et al. (2001), Bekaert et al. (2005)), this problem warrants close attention.
To reduce investors’ excessive exposure to crisis effects (Chow et al. (1999)), this study builds “crisis-robust” portfolios, i.e. those exhibiting the least change in volatility during crises. Such portfolios enable investors to minimize as much as possible the perverse effects of volatility caused by a crisis…