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In this report, we argue that carry traders can increase their risk adjusted returns by tracking the levels of three different inter-market indicators:  currency volatility, options risk reversals and interest rate expectations. Indeed, the correlation between forex trading returns and other financial instruments has increased notably over the last few years and we think these indicators can help traders to gauge the sustainability of carry trades.

RULE #1 Avoid Currencies With Extreme Volatility

Generally, currencies with large interest rate differential are also associated with high volatility. For instance, while the NZD/JPY has the largest carry return among the world’s most liquid currency pairs, the New Zealand dollar is also one of the most risky currency pairs to trade with nearly 14.45% of annualized volatility as implied by over-the-counter 1 month options. As a result, one carry trader can increase its risk adjusted returns by reducing his carry exposure when the market implied volatility for some carry sensitive pairs is above a certain threshold. The current levels of volatility for example favor breakout strategies and we advise our readers to reduce their carry exposure.

RULE #2 Measure Interest Rate Expectations

Additionally, changes in interest rate expectations have been for a long time the main force behind many trends in the currency market. For instance, the sharp rise in interest rate expectations for the Bank of Japan in 2006 (chart shown below) seems to be behind the largest drawdown that the carry trade has experienced in the past decade. As a result, one carry trader can increase its risk adjusted returns by closing his open positions when the BoJ is considerably hawkish. However, since interest rate expectations are both difficult to obtain and hard to measure, many traders prefer to stay away from them. We suggest to measure interest rate expectations by taking the difference between LIBOR rates with different maturity. 

RULE #3  Avoid Extreme Levels on Risk Reversals

We also recommend avoiding carry trades when the market demand for USDJPY puts is significantly stronger than the demand for USDJPY calls. This difference is known as risk reversals and can be used to gauge the market positioning towards carry trade. For example, when carry trade unwinds, USDJPY puts become more expensive as traders hedge their long carry positions. This was exactly what happened in the last summer as illustrated by the chart on the second page. At the same time carry trade was liquidated, USDJPY risk reversals fell sharply. Currently, USDJPY risk reversals are at extreme levels which means that traders continue to pay more for hedging than for carry exposure. 

 

Backtesting our Rules

We tested our filters against the DailyFX Dynamic Carry Trade Basket which is published every week on DailyFX.com. In essence, our carry trade strategy ranks the world’s most liquid currency pairs currencies according to the 3 month LIBOR rate and then we take long positions in the top 3 yielders and short in the bottom 3. Our backtested results show that carry traders can increase their risk adjusted returns by simply tracking the indicators that we have illustrated which are FX volatility, options risk reversals and interest rate expectations.