Trend and carry as a core FX strategy

The currency markets have been a place of renewed interest by investors. With the dollar in one of the strongest trends in years and continued divergence in monetary policy and growth, there are good fundamental reasons for selling other currencies. There is also reviewed interest in exploiting interest differentials, that is, to play the carry trade; however, one of the key lessons of the financial crisis has been that carry trades can be extremely risky. You just have to ask an emerging market carry trader who has financed his positions with dollars.

The high average returns for carry strategies are coupled with high negative skew and drawdowns. The high returns need to offset these risks. Recent research work has again focused on the risks associated with carry trades. See "Carry and Trend-following Returns in the Foreign Exchange Market".  While the authors focused on trying to explain the risk premium with carry, they found that trend-following seems to be a good hedge for carry trades. Carry plus trend-following is a nice combination of strategies that provides a good return to risk.

The research focused on the risk associated with carry and found that a liquidity risk premium seems to do a good job of explaining the volatility and return profile of a carry strategy. Many have known about this from trading the strategy. Simply put, when risk aversion increases or there is a risk-off environment, the smart money should get out of carry. No matter how you measure it, if there is a liquidity problem, it is time to step aside from carry. At the same time, this can usually be a good time to hold a trend-following strategy. So if you balance carry with trend-following, you will have a good natural hedge profile. 

This combination is suggestive of what we have said before about convergent and divergent trading strategies. (See momentum and mean reversion traders - they co-exist. We have also written on the dangers carry in the past.) Momentum strategies should do well when there are market dislocations or divergences. Mean reverting strategies or those that do better when markets are stable such as carry are convergent strategies. These two strategies can co-exist and can be combined to make for a better portfolio of different strategies.

Work in the FX market have suggest that carry and trend are two of the key beta strategies in the FX markets along with fundamental and volatility factors. Hence, it would be natural for carry and trend to combine for a better portfolio. This recent research just reinforces this combination story as a core approach to trading the FX markets.