dynamic carry trade basket

A Rebound In Liquidity May Put Risk And Carry Trade Interests Back On Pace

Friday, 02 January 2009 22:07:41 GMT  |  John Kicklighter, Currency Strategist

The new year has begun; and the impending rebound in liquidity promises to redefine direction for risk sentiment and its dependable barometer – the carry trade. Now, the market is left to decide whether the rebound in activity will mean a revival of the sweeping deleveraging trend through October or a rebound in risk appetite - and there are fundamental and technical arguments on both sides of the market.

• A Rebound In Liquidity May Put Risk And Carry Trade Interests Back On Pace
• Employment And Growth Reports To Revive Recession Discounting Next Week
• Expected Bank Of England Rate Cut Will Further Unbalance Carry Risk / Reward

The new year has begun; and the impending rebound in liquidity promises to redefine direction for risk sentiment and its dependable barometer – the carry trade. Now, the market is left to decide whether the rebound in activity will mean a revival of the sweeping deleveraging trend through October or a rebound in risk appetite - and there are fundamental and technical arguments on both sides of the market. Looking at our gauge for risk appetite (the DailyFX Carry Trade Index) we can see that the thin markets of the past few weeks restricted a definitive shift in sentiment. However, congestion has gone back further than just the two-week holiday period. Carry interest has been ‘basing’ since the exhaustion move through the end of October – marking the height of broad panic that was overwhelming the money and capital markets through much of the summer. Moving forward, the months of congestion looks strikingly like a reversal pattern; but it is important to note that the market is still near its multi-year lows. What’s more, volatility in the currency markets is still excessively high and global interest rates are expected to contract further.

More important to forecasting the future of risk sentiment and carry interest is weighing the fundamental influences that will play upon market participants. Optimists and bulls can find some comfort in the claim that considerable deleveraging and fear have been exercised through the second half of 2008. This is a purely speculative claim, but one that is finding more traction through references to P/E ratios and the efforts made by policy officials to draw the toxic debt out of the market and restore confidence in lending. On the other hand, a comparison to the fundamental point we are at now and during the panic selling through September and October reveals that conditions have actually worsened. It is true that we may not see the sharp drop that represented the perfect storm of pessimism that was catalyzed by the potential failure of a major US financial institution (AIG); but forecasts are nevertheless dour. US auto-manufacturers required a sizable bailout; but this was only the first of many troubled industries outside of the financial sector that was forced to step forward. With a deepening global recession - that is now hitting high gear as consumer wealth and spending plunge – there will be far less activity, which further means a drop in spending, investment and yields. Expected returns will be a pivotal factor in 2009. Risk is still high and will likely remain that way for some time. However, the promise of a high yield can easily balance this equation. The problem is: global interest rates are approaching zero and frozen credit markets further dampens the hope for returns.

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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