Standard carry trades, which consist of purchasing high- and selling low-yield currencies, provide an economic diversification effect. However, the diversification effect is not robust, and is not borne out by much statistical evidence. We introduce optimized carry trades, which incorporate risk components in the currency selection process. These optimized carry trades provide a diversification effect and robustly enhance the risk-return profile of an underlying portfolio, both economically and statistically. Furthermore, optimized carry trades are applicable as a cash overlay strategy to improve the contribution of a cash position and enhance the portfolio return. The positive contribution of the cash overlay with optimized carry trades is larger than with standard carry trades.

Keywords: Diversification Effect, Carry Trade, Portfolio Optimization, Alternative Asset Class

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