Optimal Dynamic Carry Trades

Paper Proposal
David Grad
November 30, 2008
1 Forecasting and Exploiting Deviations from Uncovered Interest
Parity
1.1 A Brief Overview of Uncovered Interest Parity and its Failure
Uncovered interest parity (UIP) states that under risk neutrality and rational expectations, the change in
the spot exchange rate between two countries over a certain period should be equal to the interest dierential
between them:
1
t
(:
t+1
:
t
) = i
t
i

t
(1)
where :
t
is the log of the spot exchange rate and i
t
, i

t
are the domestic and foreign nominal interest rates
respectively.
The covered interest parity condition, an arbitrage condition which is accepted to hold, states that the
forward exchange rate over a certain time period less the spot rate must be equal to the interest dierential
over the same time period:
)
t
:
t
= i
t
i

t
(2)
where )
t
is the log of the forward rate. By substituiting this condition into (1) above and assuming rational
expectations, uncovered interest parity is generally tested by running the following OLS regression, sometimes
called the Fama (1984) regression
1
:
:
t+1
:
t
= c +,()
t
:
t
) +-
t
(3)
If UIP holds, we would expect to nd c = 0, , = 1 and -
t
to be uncorrelated with information available at
time t 1. An enormous literature which tests this hypothesis nds that UIP does not tend to hold: most
commonly, , is found to be negative so that high interest rate currencies actually tend to appreciate relative
to low interest rate ones. This has been coined the "Forward Premium Puzzle", of which surveys can be
found in Hodrick (1987), Froot and Thaler (1990) and Engel (1996). I reconrm the failure of UIP below at
1
Although Fama (1984) is most commonly cited as the beginning of the forward premium puzzle literature, Bilson (1981) is
generally credited with nding that high interest rate currencies tend to appreciate relative to low interest rate ones, although
this has been disputed by Rogo (2007) who attributes the nding to Tryon (1979). Still others attribute the Fama regression
to Mincer and Zarnowitz (1969).
1
a daily frequency, using exchange rate data on spot and one month forward exchange rates downloaded from
Datastream. Following the methodology of Flood and Rose (1997), I use daily data which as they point out
induces serial correlation in the errors due to the overlapping maturity periods of the one month forward
rates. As they do, I correct for this by using Newey-West standard errors. The regression results are given
below:
R
2
Japan -0.0027 -0.6665 0.0014
(0.0033) (0.9682)
Norway -0.0022 -1.1829 0.0064
(0.0019) 0.8207
Sweden -0.0037* -3.166** 0.0347
(0.0017) (0.8848)
Switzerland -0.0093** -3.4376** 0.0244
(0.0027) (1.0532)
United Kingdom -0.0003 -1.4371 0.0055
(0.0016) (1.0492)
Europe -0.0044** -3.822** 0.0376
(0.0016) (1.0257)
Australia 0.0013 -3.4001** 0.0267
(0.0025) (1.1136)
New Zealand 0.0042 -3.2** 0.0242
(0.0032) (1.0312)
Tests of Uncovered Interest Parity using the equation
:
t+1
:
t
= c +,()
t
:
t
) +-
t
, where :
t
is the log of the spot
exchange rate quoted at date t and )
t
is the log of the one
month forward rate quoted at date t. Spot and forward rates
are taken at the daily frequency. Newey-West standard
observations in parentheses (with 8 lags). * and ** denote
signicance at the 5 and 1 percent levels respectively. 2,477
observations.
Similar to results that have been documented, I nd a consistent negative sign on ,, which is generally
signicant. A result of this nding is that excess returns may accrue to investors who borrow in low interest
rate currencies and use the proceeds to invest in high interest rate currencies (or equivalently, buy high
interest rate currencies in the forward market against low interest rate ones). As long as the higher yielding
currency does not depreciate by more than the interest dierential accrued, the trade will be protable. The
fact that these currencies actually tend to appreciate results in an extra source of return. In fact, Jurek
(2008) shows that only between one half to one third of carry trade prots are due to interest, the remainder
coming from favorable currency movements. This strategy is known in practice as the carry trade; the
investment strategy that I wish to investigate.
This proposal is motivated by a desire to attempt to adequately measure the economic benet that
accrues to an investor who engages in the carry trade investment strategy, a strategy that exploits the
2
existence of the forward premium puzzle. There has been a recent spate of papers tracking the extent of the
forward premium puzzle by measuring the gains from the carry trade. My proposal is to extend this branch
of literature while taking into account some established properties of carry trade returns. In particular:
1. Although traditional tests of the Uncovered Interest Parity condition nd that high interest rate cur-
rencies appreciate relative to low interest rate ones, this relationship does not appear to be stable over
time. In particular, the regression based tests tend to exhibit parameter instability, which may aect
an investors decision as to when to enter the carry trade or may prevent her from realizing consistent
prots.
2. Carry trade returns tend to fall in times of high volatility. Thus, by forecasting future exchange rate
volatility an investor can better time when to get in and out of the carry trade. This is known as a
"volatility timing" eect.
3. Investors should form an optimal portfolio of currencies which maximizes their utility function. Recent
papers either do not construct optimal portfolios or do so in a framework in which the investors
utility is only aected by the mean and variance of returns. Given that carry trades have been
shown to have positive returns and low volatility but signicant negative skewness and "crash risk",
such a measurement may overstate the attractiveness of the carry trade. Consequently, it is especially
important to incorporate higher moments of returns into the utility function when constructing optimal
portfolios.
4. Investors should be able to maximize utility and rebalance their portfolios frequently. I consider daily
data in this proposal. Given the susceptibility of carry trades to sudden crashes, constraining an
investor to wait until the end of the month or quarter to rebalance her portfolio may distort the
measurement of economic gains. This is the "dynamic" portion of the exercise.
My strategy is to consider a representative investor who takes advantage of the forward premium puzzle
by engaging in the carry trade. Each day, the investor forecasts the returns to engaging in the carry
trade taking into account parameter instability and changing volatility. Equipped with these forecasts, the
investor constructs an optimal portfolio to allocate her wealth across currencies in order to maximize her
utility function in a framework that accounts for the skewness of currency returns. The goal is to measure the
utility gain to the investor who uses an approach which takes parameter instability and changing volatility
into account versus one who uses an approach which does not, or which forecasts exchange rates by another
method.
This proposal precedes a paper which would ultimately be empirical. In this proposal, I rst briey
review the literature in the areas closest to my idea, emphasizing a recent paper by Della Corte, Sarno and
Tsiakas (2008) which motivated this proposal and which my paper would use as a starting point. While this
recent paper takes into account point (2) above relating to volatiltiy timing, the authors do not consider the
impact of the other three. The remainder of this proposal considers each of the four points above in greater
detail to motivate the importance of these extensions in the context of the carry trade.
1.2 Relation to Existing Literature
A large and ever-growing literature exists which attempts to explain the observed deviations from UIP.
Surveys can be found in Hodrick (1987), Froot and Thaler (1990) and Engel (1996). Common methodolo-
gies attribute the failure of UIP to time-varying risk premia, expectational errors, peso problems, market
3
microstructure issues and liquidity. At the same time, a smaller literature has developed which does not
attempt to explain deviations from UIP directly, but rather attempts to measure the economic benet that
can accrue to an investor who takes advantage of the failure of UIP by borrowing in lower yielding currencies
to invest in high yielding ones. This "trading strategy" framework was in fact proposed by Bilson (1981),
who is often credited as the rst to nd the existence of the forward premium puzzle. Other examples of
papers in this vein are Backus, Gregory and Telmer (1993), Hochradl and Wagner (2008) and Villanueva
(2007) who points out that "few studies examine forward bias trading prots even though signicant re-
turns dene the economic signicance of an anomaly". At present, two main papers in this area are those by
Burnside, Eichenbaum, Kleshchelski and Rebelo (2006, 2008) who similarly propose measuring the economic
signicance of the failure of UIP by documenting the amount of money that can be made from exploiting
UIP deviations. Using monthly data from 1976, they investigate the returns that accrue when an investor
adopts a strategy of buying currencies whose interest rate is higher than the base currency, and selling those
whose interest rate is lower, where the base currency is taken as either the dollar or the pound. This strat-
egy is undertaken for individual currencies, for a portfolio where one invests equally across each currency
considered in their data set and for an optimal portfolio which maximizes investor utility over the mean and
variance of returns in a classic Markowitz framework. For each strategy, the authors nd that one would
have made signicant prots by engaging in the carry trade with low volatility of returns (i.e. carry trades
exhibit high Sharpe ratios
2
) and that these returns are not a compensation for risk. Returns tend to increase
when portfolios are constructed in a utility optimizing (mean-variance) framework. They also show that
carry trade returns tend to be quite negatively skewed, and that this skewness cannot be diversied away
by forming portfolios. This property is reconrmed recently by Jurek (2008) and Brunnermeier, Nagel and
Pedersen (2008).
Most closely related to my proposal is a recent paper by Della Corte, Sarno and Valente (2008). The
authors point out that in the context of dynamic asset allocation strategies, there is no study assessing the
economic value of the predictive ability of empirical exchange rate models which condition on the forward
premium while allowing for volatility timing. They investigate whether the statistical rejection of UIP
generates economic value to a dynamically optimizing investor who exploits the UIP violation in order to
generate excess returns. This is done in a framework where the investor forecasts next periods exchange
rate based on the current forward premium ()
t
:
t
) and allows for "volatility timing" by using a stochastic
volatiltiy model to forecast next periods volatility. In this context, a dynamic asset allocation strategy
refers to a portfolio whose shares shift according to current information while volatility timing means that
the investor conditions on a forecast of future volatility when making her portfolio allocation decision. The
exchange rate model used by investors to forecast returns is given by
:
t
= c +,()
t1
:
t1
) +n
t
(4)
n
t
=
t
-
t
, -
t
11(0, 1)

t
= exp
_
/
t
2
_
/
t
= j +c(/
t1
j) +oj
t
, j
t
11(0, 1)
This is the Fama regression (3) above augmented to include a stochastic volatility component. Each month,
the investor forecasts the return to investing in each currency by estimating the above model to arrive at an
2
The Sharpe ratio is equal to the mean excess return (return over the risk free rate) of an investment strategy, divided by
the standard deviation of its returns.
4
estimate of next months expected return mean and variance. The authors consider monthly data from 1976
to 2004 on the British Pound, Deutschemark (the Euro post 1998) and Japanese Yen versus the US dollar.
Della Corte, Sarno and Tsiakas then specify an optimal portfolio rule by which an investor allocates her
wealth across currencies. This rule is developed from the classic Markowitz portfolio allocation framework
where an investor maximizes her utility function over wealth in each period. Utility is a function of the rst
two moments of next periods expected returns only. Given an estimate of next periods mean and variance
from (4) above, the investor can allocate her wealth across currencies by maximizing her utility function.
The drawback of this framework, which I will expand on below, is that it implicitly assumes either that the
underlying returns are normally distributed or that investors have a quadratic utility function so that only
the rst two moments of returns are relevant to their utility function (Della Corte, Sarno and Tsiakas assume
quadratic utility). This strategy of using the model (4) to allocate wealth is compared to other strategies
such as a simple random walk, a monetary exchange rate model, the same model which assumes constant
volatility and the model with a GARCH rather than stochastic volatiltiy specication. To measure the
economic benet, the authors compare the level of average utilty generated by each estimate of conditional
mean and variance. The strategy based on (4) above is found to consistently provide the highest economic
benet to a utility maximizing investor, leading the authors to conclude that there is signicant economic
benet to an investor who exploits deviations from UIP by forecasting currency returns using this model.
1.3 Parameter Instability and Market Timing
Although most empirical studies nd that the estimated value of , in (3) above is less than one (and usually
negative), it has also been pointed out that , exhibits parameter instability (for example Bekaert and Hodrick
(1993), Baillie and Bollerslev (2000)). Accounting for the instability in the relationship betwen the exchange
rate and the interest dierential should be a consideration of an investor who uses a model based on the UIP
regression (3) to enter into a carry trade strategy. The instability of , is a component that will aect the
time-varying returns of the carry trade strategy. By accounting for the parameter instability more explicitly,
it may be possible to determine whether there is an additional market timing eect of being able to time
when to enter and exit the carry trade (that is, to enter when beta is expected to be negative and to exit if
it reverts to being positive). On the other hand,the instability of , may be an impediment to the realization
of consistent carry trade prots.
To investigate the existence and extent of parameter instability in the UIP regression, I follow the
methodology used by Ang and Chen (2007) to motivate time-varying parameters in their paper
3
, and look
at rolling OLS estimates of beta. I calculate the coecients of (3) above using a rolling 500 day window. I
plot the results below versus the full sample OLS estimate, which is indicated by the solid black line. From
this exercise, there appears to be evidence of parameter instability. Although an investor should be able to
prot on average from investing in high interest rate currencies, there are periods in which the correlation
of the spot rate and the forward premium switches signs completely, in which case it would be optimal to
stay out of the carry trade in that currency. This is the market timing eect which I would like to take into
account in my paper.
3
See also Baillie and Bollerslev (2000) and Bekaert and Hodrick (2008)
5
0 500 1000 1500 2000
-50
0
50
JPY
0 500 1000 1500 2000
-20
-10
0
10
NOK
0 500 1000 1500 2000
-20
0
20
SEK
0 500 1000 1500 2000
-40
-20
0
20
CHF
0 500 1000 1500 2000
-20
0
20
GBP
0 500 1000 1500 2000
-20
-10
0
10
EUR
0 500 1000 1500 2000
-20
0
20
40
AUD
500 Day Rolling Betas of UIP Regression: Jan 1999 - July 2008
0 500 1000 1500 2000
-20
0
20
NZD
, coecient of the UIP regression :
t+1
:
t
= c +,()
t
:
t
) +-
t
over a 500 day rolling window. The solid black line
indicates the full sample OLS value of beta from Table 1 above.
To more formally document the existence of parameter instability, the table below reports the sample
statistic and p-value of a Quandt-Andrews test for time-varying parameters suggested by Rossi (2005). The
null hypothesis that parameters are not time-varying is rejected for all currencies.
6
Quandt-Andrews Statistic p-Value
Japan 33.50 0
Norway 61.11 0
Sweden 142.00 0
Switzerland 79.75 0
U.K. 67.47 0
Euro 92.84 0
Australia 53.83 0
New Zealand 94.61 0
Quandt-Andrews Tests for Parameter Stability
1.4 Stochastic Volatility and Volatility Timing
Times of high volatility have generally been shown to be times of negative returns to the carry trade; that
is, when volatiltiy is high the forward premium puzzle is less pronounced. Bhansali (2008) makes the point
that investing in the carry trade is equivalent to a bet that volatiltiy will be low, while Brunnermeier Nagel
and Pedersen show that the expectation of higher volatiltiy in the future, as measured by the VIX, leads to
losses on the carry trade. Consequently, there are benets to an investor of being able to forecast volatility
and exit investments in those currencies that are expected to be more volatile in the future. Della Corte,
Sarno and Tsiakas (2008) show that a log stochastic volatility model added onto (3) is superior to either a
GARCH model or assuming that volatiltiy is constant. Hence, there are benecial volatilty timing eects
that can accrue to an investor by forecasting volatilty through a stochastic volatility model
4
.
2 Constructing Optimal Carry Trade Portfolios
Given a statistical framework which conditions on the forward premium to forecast exchange rate returns
while allowing for time-varying parameters and stochastic volatility, the next step is to propose a framework
where an investor uses these forecasts to optimally allocate her wealth across a portfolio of currencies. This
would result in an optimal carry trade portfolio.
When looking at carry trades from an investor point of view, recent papers either use an ad-hoc allocation
rule (such as allocating equal weight to each currency or investing in the top three interest rate currencies
equally nanced by selling the bottom three interest rate currencies) or have used mean-variance analysis to
ascertain optimal portfolios. For example, Della Corte, Sarno and Tsiakas use a mean-variance framework to
come up with their allocation rule. This requires only that an investor plug in an estimate of the mean and
variance-covariance matrix of her portfolio from the above model into an optimal allocation rule to arrive at
her utility maximizing portfolio. Using this framework, they deduce the economic benet that arrives to an
investor who uses (4) above to forecast exchange rates. Other than using such a mean-variance framework,
I have not seen any examples of optimal carry trade portfolios in the literature.
The issues resulting from the use of mean-variance analysis have long been known, but they are easier
to justify in an individual equity allocation framework (where mean-variance analysis is more commonly
used) than in a currency carry trade framework. While I will not go into a full exposition of mean-variance
analysis here, in order to justify its use one must assume either that investors have a quadratic utility
4
An alternative way to forecast exchange rate volatility would be to use implied volatilities taken from currency options.
Christoersen and Mazzotta (2005) have shown that the implied volatiltiy of currency options provide good forecasts of realized
volatility. Previous studies, surveyed in Poon (2005) have shown the implied volatilities of currency options to be superior in
forecasting future volatility than GARCH models.
7
function, or that returns follow a normal distribution. Assuming that a quadratic utility function has the
implication that the investor only cares about the mean and variance of returns, suggesting that the variance
is the sole source of risk. Although we may admit a symmetric distribution with fatter tails such as a t-
distribution in this framework, it does not allow the investor to care about skewness. Yet carry trade
returns are somewhat unique in that they have been shown to exhibit low volatilty, positive returns, but
persistent negative skewness and "crash risk" (Burnside, Eichenbaum, Kleshchelski and Rebelo (2005, 2008),
Brunnemeier Laisse and Pedersen (2008), Jurek (2008), Farhi and Gabaix (2008)). These ndings have led
to creative array of similes used to describe engaging in the carry trade, such as describing the carry trade
as being "like picking up dimes in front of a steamroller" or as having returns that "go up by the stairs
and down by the elevator". In such a non-Gaussian framework, mean-variance analysis may consequently
overstate the economic benet (and understate the risk) to investing in the carry trade as these strategies
will exhibit favourable Sharpe Ratios. One may think of the case of persistently selling out of the money
put options on the S&P 500; over most periods this would exhibit a high Sharpe Ratio and would appear to
be a desirable strategy in the mean-variance framework, yet one would likely not think of this as a low risk
strategy in reality.
2.1 Properties of Carry Trade Returns
To document the properties of carry trade returns, I follow Burnside, Eichenbaum, Kleshchelski and Rebelo
(2006, 2008) and consider the return to one dollar invested at each day in the carry trade by invoking
the strategy of buying high yielding currencies and selling low yielding ones. Letting r
t
denote one dollar
invested at time t for each currency pair, the strategy can be summarized as
r
t
=
_

_
+1 if 1
t
o
t
1 if 1
t
< o
t
0 otherwise
_

_
where 1
t
is the level of the one month forward rate and o
t
is the level of the spot rate. The carry trade
payos .
t+1
one month forward are then dened as
.
t+1
=
_

_
r
t
(1
t
,o
t+1
1) if r
t
0
r
t
(1
t
,o
t+1
1) if r
t
< 0
0 if r
t
= 0
_

_
The table below documents the properties of daily carry trade returns, .
t+1
. Carry trade returns tend
to be positive (with the exception of Switzerland over this sample) and volatilty appears reasonably low.
Yet they generally display negative skewness (the UK and Norway being the exception) and excess kurtosis.
Following Jondeau and Rockinger (2006), I test for the normality of returns using the standard Jarque-Bera
test as well as the Omnibus test
5
. Aside from the Euro and Norway, the null hypothesis of normality at the
5% level.
5
Jondeau and Rockinger note that the Jarque-Bera test, which is a joint test of whether skewness and kurtosis are jointly
zero, is only suitable for very large samples as it uses the asymptotic distribution of the estimators. The omnibus test corrects
the Jarque-Bera test to be used in smaller samples as it is based on the approximated nite-sample distribution of skewness
and kurtosis.
8
Australia Switzerland Euro UK Japan Norway
Mean 0.0072 -0.0003 0.0069 0.0019 0.0029 0.0040
Std. Dev. 0.0310 0.0291 0.0272 0.0231 0.0286 0.0298
Skewness -0.4631 -0.3349 -0.1153 0.0750 -0.1727 0.0179
Kurtosis 3.5189 2.6787 2.9772 3.2157 3.0639 2.8072
Sharpe Ratio 0.2333 -0.0116 0.2521 0.0813 0.0999 0.1348
Maximum 0.0918 0.0650 0.0846 0.1031 0.1036 0.0860
Minimum -0.1472 -0.1039 -0.0946 -0.0903 -0.1171 -0.0869
Normality Tests:
Jarque-Bera 116.34 56.96 5.54 7.12 12.73 3.97
p-Value 0.0000 0.0000 0.0625 0.0284 0.0017 0.1374
Omnibus 62.7841 103.1710 9.4097 8.2053 140.7352 2.6276
p-Value 0.0000 0.0000 0.0091 0.0165 0.0000 0.2688
New Zealand Sweden
Mean 0.0082 0.0085
Std. Dev. 0.0347 0.0291
Skewness -0.7037 -0.0963
Kurtosis 4.3106 2.8292
Sharpe Ratio 0.2350 0.2930
Maximum 0.1137 0.1095
Minimum -0.1669 -0.1146
Normality Tests:
Jarque-Bera 381.68 6.84
p-Value 0.0000 0.0326
Omnibus 158.5451 7.9478
p-Value 0.0000 0.0188
Summary statistics of monthly carry trade returns .
t+1
, given by the strategy dened by
.
t+1
=
_

_
r
t
(1
t
,o
t+1
1) if r
t
0
r
t
(1
t
,o
t+1
1) if r
t
< 0
0 if r
t
= 0
_

_
. Returns are monthly, as they depend on the one
month forward rate, but are observed at a daily frequency. The Sharpe Ratio is equal to the
mean return divided by its standard deviation. Jarque-Bera and Omnibus tests are tests of
the null hypothesis that returns are distributed normally.
2.2 Optimal Portfolio Allocation with Non-Normal Returns
The shortcomings of utilizing mean-variance analysis to construct optimal portfolios are well known, but
there is not one agreed upon alternative framework. Some recent papers have begun to revisit this issue in
the case of equity allocation by investigating how an investors asset allocation pattern changes when higher
moments are added to her utility function. I explore here an approach proposed by Jondeau and Rockinger
in a recent series of papers (2006, 2008, Jondeau Poon and Rockinger (2007)).
Jondeau and Rockinger note that there are generally two approaches to the problem of constructing
optimal portfolios when the underlying returns are not normally distributed or when investors care about
9
return moments other than the mean and variance. The rst involves positing distributional assumptions
on asset returns, and then maximizing the utlity function directly. While this provides an exact solution to
the investor maximization problem, it generally involves large computational burdens in terms of numerical
integration of the expected utility. Consequently, most studies can only focus on a relatively small number
of assets. The second approach is to approximate the expected utility function prior to optimization (for
example, by a Taylor Series expansion). Through the approximation, one attempts to incorporate higher
moments of portfolio returns into the utility function directly. It is this second approach that I propose here.
To formalize this idea, I follow Joneau and Rockingers exposition and consider a framework in which
there is an investor who chooses to allocate her portfolio among a set of investments by maximizing next
periods expected utility of wealth, 1
t
(l(\
t+1
)). Initial wealth is arbitrarily set to be one. In each period,
the investor may allocate her wealth among : risky assets, with returns r
t+1
= (r
1;t+1
, ..., r
n;t+1
)
0
and a
risk-free asset with return r
f;t
. Letting n
t
= (n
1;t
, ..., n
n;t
) denote the vector of the fraction of wealth
allocated to each asset, the portfolio return in each period is equal to r
p;t+1
= r
f;t
+n
0
t
(r
t+1
r
f;t
), so that
end of period wealth is equal to \
t+1
= 1 + r
f;t
+ n
0
t
(r
t+1
r
f;t
i), where i is an : 1 vector of ones. In
the carry trade example above, each asset would be a risk-free bond in a dierent foreign country, while the
riskless asset would be a riskless bond in the home country. The weight on the risk-free asset is given by
n
0;t
= 1
n

i=1
n
i;t
.
The investor chooses the optimal allocation of wealth to each asset in each period, n

t
, by maximizing
next periods expected utility:
n

t
= arg max
fwtg
1
t
[l (\
t+1
(n
t
))] = 1
t
_
l
_
1 +r
f;t
+n
0
t
(r
t+1
r
f;t
i)
__
(5)
s.t.
n

i=0
= 1
To incorporate higher moments directly into the utility function, we can approximate expected utility by a
fourth order Taylor expansion around expected wealth
6
1
t
[l (\
t+1
)] =
1

k=0
d
k
n(\)
d\
k
1
t
_
(\
t+1
1(\
t
))
k
_
n(\
t
) +
dn(\
t
)
d\
t
:
p;t+1
+
_
1
2
_
d
2
n(1(\
t
))
d\
2
t
:
(2)
p;t+1
+
_
1
3!
_
d
3
n(\
t
)
d\
3
t
:
(3)
p;t+1
+
_
1
4!
_
d
4
n(1(\
t
))
d\
4
t
:
(4)
p;t+1
where :
(k)
p;t+1
= 1
t
_
(\
t+1
1(\
t
))
k
_
and refer to the non-central moments of order i . In this way we
can incorporate skewness and kurtosis into the investors utility function. Under certain conditions which
Jondeau and Rockinger establish, it can be shown that such an investor likes positive skewness and dislikes
kurtosis. In the quadratic utility cased utilized by Della Corte, Sarno and Tsiakas (2008), the last two terms
are zero so that the approximation is exact and the investor only cares about the rst two moments.
By putting a functional form on the utility function, we can complete the investors allocation problem
at each time period t. For example, in the case of a power utility function l(\
t+1
) =
W
1
t+1
1
, where is a
6
An alternative is to optimize the utility function directly. Jondeau and Rockinger show that this is much more computa-
tionally burdensome and consequently can only be used when looking at a small number of assets.
10
measure of relative risk aversion, we have
1
t
[l (\
t+1
)]
1
1


2
:
(2)
p;t+1
+
( + 1)
3!
:
(3)
p;t+1

_
( + 1) ( + 2)
4!
_
:
(4)
p;t+1
(6)
where in this case it is clear that expected utility decreases with negative skewness and positive kurtosis.
Maximizing the expression (6) at each date t denes a dynamic asset allocation strategy that maximizes
investor utilty in each period. Given a forecast of next periods mean, variance skewness and kurtosis of
each asset return, the investor chooses to optimally allocate her wealth at each date among the various risky
assets and the risk free rate.
3 Empirical Strategy
Given the above discussion, I can now propose a rough empirical strategy. Consider daily data on a set of
the major currencies. Given the fact that the forward premium ()
t
:
t
) tends to predict the future spot
(log) exchange rate :
t+1
, a simple stochastic volatiltiy model, and daily rebalancing, a basic model used by
an investor every day to forecast the exchange rate is given by
:
t
= c +,
t
()
t1
:
t1
) +n
t
(7)
n
t
=
t
-
t
, -
t
11(0, 1)

t
= exp
_
/
t
2
_
/
t
= j +c(/
t1
j) +oj
t
, j
t
11(0, 1)
This model is identical to that found in Della Corte, Sarno and Tsiakas (2008), with the exception of the
time subscript on , to take into account the fact that beta itself varies over time and the daily frequency
of data. A remaining question is what the best way to make ,
t
time varying in this framework is. One
possibility is to follow Ang and Chen and specify an AR(1) process for ,
t
:
,
t
= ,
0
+c,
t1
+o

-
;t
Each day this model will give a forecast of the conditional mean and variance of carry trade returns.
At the same time, consider an investor with a standard CRRA utility function, l(\
t+1
) =
W
1
t+1
1
. Every
day, she rebalances her portfolio by maximizing utility over welath, solving the problem
n

t
= arg max
fwtg
1
t
_
\
1
t+1
1
_

1
1


2
:
(2)
p;t+1
+
( + 1)
3!
:
(3)
p;t+1

_
( + 1) ( + 2)
4!
_
:
(4)
p;t+1
s.t.
n

i=0
= 1
Given an estimate of conditional mean, variance, skewness and kurtosis of carry trade returns, the investor
can solve the above utility function to allocater her wealth optimally across currencies. Of course, the
11
strategy so far is incomplete as the moel (7) above only forecasts the rst two moments. One possibility to
begin with would be to use simple rolling estimates of skewness and kurtosis.
Once a framework such as the one above has been established, it is possible to compare the utility
accrued from utilizing this model to that of dierent models: either dierent models exploiting UIP which
drop assumptions of time-varying betas, stochastic volatility, or higher moments in the utility function or
alternative exchange rate models such as the random walk.
12
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