Tim Olson
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description, tags
| description | tags | ||||
|---|---|---|---|---|---|
| Dollar carry trade that goes long or short all foreign currency forwards simultaneously based on the average cross-sectional forward discount relative to the USD. |
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Dollar Carry Trade
Section: 8.3 | Asset Class: FX | Type: Carry / Macro
Overview
Rather than sorting currencies into long and short buckets based on individual forward discounts, the dollar carry trade takes a uniform long or short position in a basket of N foreign currencies relative to the USD. The signal is the average forward discount across all currencies. When this average is positive, the dollar is expensive on a carry basis and all foreign currency forwards are bought; when negative, all are sold. This trade is related to the broad strength or weakness of the U.S. economy.
Construction / Mechanics
Compute the average cross-sectional forward discount for a basket of N currencies:
D_bar(t,T) = (1/N) Σ D_i(t,T) (444)
where D_i(t,T) is the forward discount for currency i (see Eq. 442 in carry-trade.md).
Trade logic:
- D_bar(t,T) > 0: go long all N foreign currency forwards with equal weights
- D_bar(t,T) < 0: go short all N foreign currency forwards with equal weights
- T can be 1, 2, 3, 6, or 12 months
Return Profile
Profits when the average forward discount correctly predicts the net direction of the USD against the foreign currency basket. Empirical evidence links positive average forward discounts to weak U.S. economic conditions, so the strategy also provides indirect macro exposure.
Key Parameters / Signals
| Parameter | Description |
|---|---|
| N | Number of foreign currencies in the basket |
| T | Forward contract tenor (1, 2, 3, 6, or 12 months) |
| D_bar(t,T) | Average forward discount; positive = go long all forwards, negative = go short |
Variations
- The equal-weight long/short rule can be replaced by a weight proportional to each currency's individual D_i to incorporate cross-sectional dispersion.
- The basket can be restricted to G10 currencies or expanded to include EM currencies.
Notes
- The strategy is not dollar-neutral; it is an explicit bet on the direction of the USD versus a broad basket.
- Unlike the HML carry trade (Section 8.2.1), this strategy does not hedge out the common dollar factor and thus carries more systemic risk.
- Performance is empirically linked to U.S. business cycle conditions: when the U.S. economy is weak, the average forward discount tends to be positive, making the trade profitable in a carry sense.
- Correlations across currencies in the basket can be high during crisis periods, reducing the diversification benefit.