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Panic Eases But Conditions Far From Favorable For Risk Appetite And The Carry Trade

Saturday, 01 November 2008 00:47:53 GMT  |  John Kicklighter, Currency Strategist

Panic, which has driven volatility and positioning through much of October, has eased its strangle hold on the market – for now. While liquidity fears have been quenched by unlimited access to dollar funds, sharp interest rate cuts and global bailout efforts, the markets have merely passed through one phase of a much broader financial crisis.

• Panic Eases But Conditions Far From Favorable For Risk Appetite And The Carry Trade
• Ongoing Credit Crunch And Efforts To Deleverage Keep Banks, Investors And Economies Under Pressure
• Can The Carry Trade Recover While Global Interest Rates Are Still Falling?

Panic, which has driven volatility and positioning through much of October, has eased its strangle hold on the market – for now. While liquidity fears have been quenched by unlimited access to dollar funds, sharp interest rate cuts and global bailout efforts, the markets have merely passed through one phase of a much broader financial crisis. A good indicator that conditions are not back to normal is an objective view of the where the market benchmarks and indicators that measure risk are at. As a gauge of carry interest and general risk appetite, the DailyFX Carry Trade Index has jumped nearly 1,450 points since last Friday (when panic was at its peak). However, from a longer-term perspective, the strategy is still 30 percent off the highs set last summer and just off six year lows. Other gauges of the investment environment are similarly weak. The options market shows a strong skew towards premiums for puts – suggesting traders are looking for protection and not willing to take on unnecessary risk anytime soon. Far more interesting though is the level of volatility. Despite the tangible drop in fear among investors, volatility in the currency market has climbed to a new high of 22.4 percent.

After a number of aggressive moves by central banks, policy officials and private entities, the markets have finally found some semblance of stability. However, just because risk appetite and asset prices are no longer in free fall doesn’t mean that conditions will improve from here. Most of the policy that was enacted over the past few months was aimed (deliberately or not) at reviving lender and investor confidence – and there are still blaring problems on both fronts. Credit conditions are still very tight as default risk climbs to new record highs and rates on everything but the shortest termed money market funds (which are being artificially propped up by central bank activity) are still extraordinarily wide. Considering the long-term implications of this financial crisis - arguably the worst since the Great Depression -  there is good reason for banks and investors to remain cautious. One prominent risk that can’t seem to be reconciled by a government guarantee is counterparty risk as banks, businesses and consumers are still painfully overleveraged through credit. This credit must be worked off, or an artificial build up would merely lead to an even more dramatic collapse later down the line. The next issue: recession. When the global economy is shrinking, lending, spending and investing naturally contract.

Is Carry Trade a Buy or a Sell? Join the DailyFX Analysts in discussing the viability of the Carry Trade strategy in the DailyFX Forum

 

 

 

Risk Indicators:	Definitions:
	What is the DailyFX Volatility Index:   The DailyFX Volatility Index measures the general level of volatility in the currency market. The index is a composite of the implied volatility in options underlying a basket of currencies. Our basket is equally weighed and composed of some of the most liquid currency pairs in the Foreign exchange market.   In reading this graph, whenever the DailyFX Volatility Index rises, it suggests traders expect the currency market to be more active in the coming days and weeks. Since carry trades underperform when volatility is high (due to the threat of capital losses that may overwhelm carry income), a rise in volatility is unfavorable for the strategy.
	What are Risk Reversals: Risk reversals are the difference in volatility between similar (in expiration and relative strike levels) FX calls and put options. The measurement is calculated by finding the difference between the implied volatility of a call with a 25 Delta and a put with a 25 Delta. When Risk Reversals are skewed to the downside, it suggests volatility and therefore demand is greater for puts than for calls  and traders are expecting the pair to fall; and visa versa.   We use risk reversals on USDJPY as it is the benchmark yen pair and the Japanese currency is considered the proxy funding currency for carry trader.  When Risk Reversals grow more extreme to the downside, there is greater expectations for the yen to gain – an unfavorable condition for carry trades.
	How are Rate Expectations calculated:   Forecasting rate decisions is notoriously speculative, yet the market is typically very efficient at predicting rate movements (and many economists and analysts even believe the market prices influences policy decisions). To take advantage of the collective wisdom of the market in forecasting rate decisions, we will use a combination of long and short-term, risk-free interest rate assets to determine the cumulative movement the Bank of Japan will make over the coming 12 months. We have chosen the Bank of Japan as the yen is considered the proxy funding currency for carry trades. To read this chart, any positive number represents an expected firming in the Japanese benchmark lending rate over the coming year with each point representing one basis point change. When rate expectations rise, the carry differential is expected to contract and carry trades will suffer.

 

 

Additional Information

What is a Carry Trade
All that is needed to understand the carry trade concept is a basic knowledge of foreign exchange and interest rates differentials. Each currency has a different interest rate attached to it determined partly by policy authorities and partly by market demand. When taking a foreign exchange position a trader holds long position one currency and short position in another. Each day, the trader will collect the interest on the long side of their trade and pay the interest on the short side. If the interest rate on the purchased currency is higher than that of the sold currency, the result is a net inflow of interest. If the sold currency’s interest rate is greater than the purchased currency’s rate, the trader must pay the net interest.

Carry Trade As A Strategy
For many years, money managers and banks have utilized the inflow and outflow of yield to collect consistent income in times of low volatility and high risk appetite. Holding only one or two currency pairs would invite considerable idiosyncratic risk (or risk related to those few pairs held); so traders create portfolios of various carry trade pairs to diversify risk from any single pair and isolate exposure to demand for yield. However, even with risk diversified away from any one pair, a carry basket is still exposed to those conditions that render this yield seeking strategy undesirable, such as: high volatility, small interest rate differentials or a general aversion to risk. Therefore, the carry trade will consistently collect an interest income, but there are still situation when the carry trade can face large drawdowns in certain market conditions. As such, a trader needs to decide when it is time to underweight or overweight their carry trade exposure.

Written by: John Kicklighter, Currency Strategist for DailyFX.com.
Questions? Comments? You can send them to John at jkicklighter@dailyfx.com.

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