dynamic carry trade basket

Carry Trade Unwinding Follows A Market-Wide Selling Of Risk

Friday, 06 June 2008 17:05:50 GMT  |  John Kicklighter and Antonio Sousa, Currency Analysts

Just a week after the DailyFX Carry Trade Index made its bullish break from the downward sloping trend channel that has defined risk appetite since last summer’s subprime meltdown, the market seems to have once again fallen back into doubt about the return of low volatility and yield friendly conditions. Since last week, the Index has pulled back $212 from a near three-month high to $28,822. Supporting the decline in price, the DailyFX Volatility Index rose to 10.26 percent - indicating concern that the market may turn to more dramatic declines. On the other hand, overall volatility is still near its lowest levels since April and risk reversals actually improved slightly to keep pressure on a very prominent declining trend. This all suggests the carry’s decline is still a minor pullback for now.

            •    Carry Trade Unwinding Follows A Market-Wide Selling Of Risk
            •    Fed Liquidity Injections Continue To Meet High Demand
            •    Market Condition Offer Mixed Outlook For Risk Appetite

Just a week after the DailyFX Carry Trade Index made its bullish break from the downward sloping trend channel that has defined risk appetite since last summer’s subprime meltdown, the market seems to have once again fallen back into doubt about the return of low volatility and yield friendly conditions. Since last week, the Index has pulled back $212 from a near three-month high to $28,822. Supporting the decline in price, the DailyFX Volatility Index rose to 10.26 percent - indicating concern that the market may turn to more dramatic declines. On the other hand, overall volatility is still near its lowest levels since April and risk reversals actually improved slightly to keep pressure on a very prominent declining trend. This all suggests the carry’s decline is still a minor pullback for now.

Though risk appetite has been on the rebound over the past few months, it is clear that traders are still very leery about the health of the fragile credit market and the availability of returns great enough to compensate for their caution. Over the past week, the credit market took a hit as major investment banks were downgraded owing to expectations for ongoing write downs and the difficulties associated with raising capital in a frugal world market. Another mild shock was delivered through the reported troubles with UK lender Bradford & Bingley, which resembled the Northern Rock situation a little too closely. Outside of these one-off events, there was no lack of evidence that liquidity was still in short supply. The Fed’s most recent $75 billion TAF auction was met with demand for $96.6 billion – the second largest bid since the Fed began started its injections back in December. What’s more, the outlook for yields was weighed down by the RBNZ’s signal that a cut could come this year and tempered expectations for Fed hikes following a jump in unemployment.

 

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Risk Indicators:	Definitions:
	What is the DailyFX Volatility Index (VIX): 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  (as implied volatility for puts is quoted as a negative percentage and implied volatility for calls is quoted as a positive percentage) 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.

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