First passage times in portfolio optimization: an analysis of currency carry trade

Abstract

Currency carry trade strategies have historically delivered notable Sharpe ratios by exploiting the failure of Uncovered Interest Parity (UIP), yet they remain vulnerable to sharp unwinds, crash risk, and high negative skewness. In this paper, we adapt and evaluate the novel first passage times model developed by Zsurkis, Nicolau, and Rodrigues(2024). We argue that this non-parametric ap proach, which explicitly accounts for intra-horizon risk, offers a potential advancement in both op timization and risk management for currency carry trades. Our empirical findings indicate that this model outperforms traditional long–short strategies and performs at least as well as mean–variance optimization, while reducing negative skewness and kurtosis.