Introductory Context
"Quantitative High-Minus-Low FX carry factor strategy. Constructing dollar-neutral currency portfolios that isolate pure cross-sectional yield differentials."
Cross-Sectional Currency Carry: The Lustig–Roussanov–Verdelhan (HML-FX) Factor
In a standard single-pair FX carry trade (such as USD/INR), the portfolio remains heavily exposed to single-currency macroeconomic risks and broad US Dollar strength. If the Dollar surges globally due to US Federal Reserve rate hikes, all foreign carry trades suffer simultaneously.
The High-Minus-Low FX Carry Strategy (HML-FX), formalized by Lustig, Roussanov, and Verdelhan (2011), constructs a truly Dollar-Neutral, Multi-Currency Carry Factor. By ranking an entire basket of global currencies by their forward discounts D_i, the strategy goes Long the Top Tercile (Highest Interest Rates) and Short the Bottom Tercile (Lowest Interest Rates). Because both legs are quoted against the same base currency, the common domestic dollar interest rate cancels out completely.
• The Dollar-Neutral Difference Identity
Differential between Currency i and Currency j:
D_i - D_j ≈ (r_i - r_domestic) - (r_j - r_domestic) = r_i - r_j
The domestic dollar interest rate r_domestic cancels out of the spread entirely, creating pure cross-sectional currency alpha.
Tercile Portfolio Construction & Zero-Dollar Neutrality
Let N be the eligible currency universe (G10 and liquid Emerging Markets):
w_i = +1 / (2 × n_H), ∑ w_{long} = +0.50
Invest 50% gross capital equally across the top 3 highest-yielding currencies (e.g. BRL, MXN, INR).
w_i = -1 / (2 × n_L), ∑ w_{short} = -0.50
Short 50% gross capital equally across the 3 lowest-yielding funding currencies (e.g. JPY, CHF, EUR).
The resulting portfolio satisfies ∑ w_i = 0 (100% dollar neutral) and ∑ |w_i| = 1.0 (100% gross allocated). Middle-ranking currencies remain completely flat.
Universe Filtering: Rejecting Pegged & Illiquid Currencies
To prevent artificial model profits, two critical universe exclusions are enforced:
- Exclusion of Pegged Currencies: Pegged regimes (such as HKD or AED) or semi-pegged currencies with high local policy rates appear to offer"risk-free" carry, but carry severe tail devaluation risk when the currency peg collapses.
- Non-Deliverable Forward (NDF) Liquidity: Emerging market currencies (such as INR, IDR, KRW) must trade with tight bid-ask spreads in offshore NDF markets to ensure low execution slippage.
Structural Risk: Global Liquidity De-Risking
During global risk-off panics (such as March 2020 or August 2024), low-yielding funding currencies (JPY and CHF) surge aggressively as carry trades are dismantled, while high-yielding emerging market currencies decline simultaneously, generating synchronized drawdowns across both legs.
Educational and Research Content Only
This quantitative specification is provided for academic backtesting and educational research. Multi-currency trading involves macroeconomic, sovereign, and exchange risks.