Memo 005: Carry and vol in practice
2025-02-10
Combining carry (FX, commodities) with vol targeting and why we cap leverage.
Carry (earning the interest rate differential or roll yield) and vol targeting (scaling exposure to hit a vol target) go together. Carry strategies are often long risk; when vol spikes, they can draw down hard. Vol targeting reduces size when vol is high, which helps.
In the database:
- FX Carry: vol-scaled long/short by interest rate differential.
- Commodity Roll Yield: backwardation capture with vol scaling.
- Vol Targeting (Multi-Asset): the pure vol-targeting overlay.
We cap leverage (e.g. 2x) even when vol targeting says we could go higher. Reason: in 2020, vol spiked so fast that scaling down with a 20d vol window was lagging. A leverage cap is a simple circuit breaker.
See drawdown for why we care about peak-to-trough, and position-sizing for how we think about risk per position.
What would change our mind? If we find a fast, robust vol estimator (e.g. 1–5 day) that doesn’t overfit, we might relax the leverage cap slightly, but we’d still keep a hard max.