Benefits of wavelet-based carry trade diversification

• Carry trade excess returns are observed on five investigated investment horizons.
• Wavelet correlation analysis reveals the temporal structure of the correlations.
• Strategies based on the wavelet correlation lead to significant diversification gain.
• Wavelet diversification benefits are more pronounced in the pre-crisis period.

This study investigates carry trade diversification opportunities and linkages of major carry trade currencies on five different investment horizons. Using daily data on eight currencies and LIBOR rates, we examine the temporal structure of correlations and assess portfolio diversification benefits with wavelet techniques. Our results indicate that positive and economically significant carry trade excess returns are observed on all investigated investment horizons. We document that strategies built on the basis of wavelet correlation lead to significant diversification benefits. These findings indicate the importance of the dynamic structure of exchange rate correlations to currency arbitrage strategies.