On the Risk and Return of the Carry Trade
The traditional carry trade has historically been highly profitable, but suffered from crash risk, the proverbial "up by the stairs and down by the elevator.” This crash risk was realized in dramatic fashion in the wake of the Lehman bankruptcy, when an investor who was long the Australian dollar and short the yen would have lost 22% in October of 2008. In sharp contrast, a dynamic diversified portfolio constructed using mean-variance analysis performs well, even during the crash. A portfolio constructed using mean-variance analysis can identify opportunities that a more heuristic method will not detect. Once sufficiently diversified, the carry trade turns out to have been a surprisingly low-risk strategy over the last 20 years.