Relationship between Currency Carry Trades and Gold Returns : A quantitative study of G-10 currencies: correlation and spillover effects for the last two decades.

Sammanfattning: Currency carry trade is an investment strategy that recently started gaining a lot of interest not only among investors and financial institutions but also academically. One of the underlying theoretical assumptions regarding the mechanisms of the foreign exchange market, the Uncovered Interest Parity has frequently been disproved in practice which has led to the conclusion that carry trade is profitable in practice. The function of a carry trade strategy is that a short position is taken in a low interest rate currency to finance a long position in another currency offering higher yields. This thesis is adding to the existing literature that is explaining the characteristics of currency carry trade but is adopting a different approach than most other recent researches that has focused on identifying especially risk factors. Gold as a financial asset has also received much attention largely due to its, contrarily to other asset classes, low dependence on macroeconomic factors. This makes gold desirable to diversify portfolios and decreasing overall risks. By investigating how the returns of currency carry trades and gold relates to each other an increased understanding in how carry trades can be beneficially included in managing portfolios are developed. Looking at a currency carry trade index, Deutsche Bank’s G10 Currency Future Harvest index, and the development of the gold price at the London bullion market for the 20 year period of 1993-2013 this research is exploring correlation, mean and volatility spillover effects. Spearman’s correlation, Vector Autoregression and a diagonal BEKK GARCH model are employed to test these effects. It also investigates if gold possesses hedge, diversifier and safe haven characteristics when combined with carry trades as it has been found to do with stock markets. This is determined by a regression analysis and supplemented by a portfolio simulation. This thesis found that there is a low positive correlation between the returns of gold and currency carry trades and that there is spillover effects as well between the two in both returns and volatility. This in addition to the regression analysis and portfolio analysis determined that there are diversification benefits by adding gold to a portfolio consisting of currency carry trade in the form of higher risk adjusted returns. However special caution has to be taken to the spillover effects as these complicate the relationship between the returns of the two variables and especially the volatility spillover effects slightly decreases the potential diversification benefit. The regression analysis concluded that gold work as a diversifier for carry trade but could not determine if it also exhibited hedge or safe haven characteristics. These findings pushes the existing understanding of carry trades forward and adds to focus of matching carry trades within a portfolio which could have implications to more efficiently match risks and returns by combining several asset classes in portfolio management.