Can implied volatility predict returns on the currency carry trade?

Abstract

Currency carry strategies have long positions in currencies with a high interest rate and short positions in currencies with a low interest rate. Currency carry strategies have generated about 5.4% return per annum (Sharpe ratio: 0.57) over the period December 1996 to May 2014. However, during the recent financial crisis, the carry strategy suffered losses of up to 20% on invested capital. We investigate whether investors could have used the implied option volatility index on the US equity market (the VIX) or the option implied volatility index from G7 currencies (the VXY) to time the currency carry trade. We examine a large set of timing strategies and find that for some specific settings excess returns can be as large as 2.5% per annum. However, when we take into account that we investigated many trading strategies, these excess returns turn out not to be statistically significant. Hence, our findings cast doubt on implied volatility as a stand-alone timing indicator for currency carry trading in real-life portfolio decisions.