Linkages of Major Carry Trade Currencies: A Wavelet analysis.

Abstract

The aim study provides the new perspective for currency portfolio management by studying the linkages of major eight currencies with an implication to the currency arbitrage strategies. The financial data for the sample of 5895 daily observations for each of eight chosen currency as well as LIBOR rates was gathered and examined for the period over the past 22 years. Wavelet analysis techniques are used to study the temporal structure of correlations, cross-correlation of volatilities and coherence spectrums of eight major carry trade currencies with U.S. dollar as base currency. Wavelet correlation analysis showed that in the group of investment currencies with high interest differential upward trend in term structure of correlations is observed. Therefore, the benefits of diversification among investment carry trade currencies are much higher at short investment horizons. Additionally, strategy built on the basis of wavelet correlations of returns and diversification efficiency ranking has led to Sharpe ratio 30% higher than the simply diversified portfolio. Further, results of wavelet cross-correlation analysis of volatility series allow investors actively involved in currency trading, in some sense, predict changes of volatility and, therefore, minimize risk. The Japanese yen volatility is leading the volatility of Australian dollar, New Zealand dollar. Perhaps, such clear lead-lag relations of Japanese yen and carry trade investment currencies are caused by the nature of currency arbitrage. Finally, results of wavelet coherence analysis indicate relatively high dependences of exchange rates at low frequencies (one year and above), while at high frequencies high degree of co-movement is observed mainly during financial crises and high volatility on the market, indicating contagion. Financial crisis of 2008 appeared to have strongest impact in terms of increased short term correlations at high frequencies, those effects can be observed today. Wavelet coherence maps also indicate an overall increase of correlation in most of the cases during the last 22 years, reflecting the facts of integration of world economies, increasing trading volume on foreign exchange market and globalization in general.