dynamic carry trade basket

Stability In Risk Appetite And Carry Unwinding Temporary As Leverage And Recession Loom

Saturday, 08 November 2008 00:38:56 GMT  |  John Kicklighter, Currency Strategist

The steady pace of carry unwinding and capital market losses has been disrupted these past few weeks as the cumulative efforts of global policy makers and central banks catches up to the market. However, with the world’s recession deepening, interest rates contracting and the market trying to work off its excess leverage, stability will not last for long.

• Stability In Risk Appetite And Carry Unwinding Temporary As Leverage And Recession Loom
• A Sharp Drop In Global Interest Rates May Delay Carry Rebound Long After Growth Improves
• Currency Market Volatility Just Below 20 Percent – Still Far Above Normal

The steady pace of carry unwinding and capital market losses has been disrupted these past few weeks as the cumulative efforts of global policy makers and central banks catches up to the market. However, with the world’s recession deepening, interest rates contracting and the market trying to work off its excess leverage, stability will not last for long. Tracking the development in risk appetite trends over the past week, the DailyFX Carry Trade Index was little moved, rising a mere 50 points to 22,085. Putting this short-term change into perspective, however, we can see that the rebound from multi-year lows is playing out as a mere relief rally. A retracement is natural following a decline as aggressive as the one we have seen since this summer. Short-side speculative interest will book profits and withdrawn capital will be lured back into the market as the temporary calm revives the demand for return. Nevertheless, volatility is still extraordinarily high at 19.75 percent and the outlook for interest rates is tumbling across the board. With risk little changed from the panic conditions of early October and returns providing even less compensation, carry will remain under pressure for some time.

In any major trend, there are short-term retracements. This is true in a technical and fundamental sense. For risk sentiment and the carry trade basket, the recent rebound comes as the panic unwinding of risky positions over the past three months was curbed and capital redistributed to find some level of income while investors awaited the return of the bull market. It may be a long wait. Data that has crossed the wires points to an accelerating recession for the global economy. Even if risk aversion was fully exercised, a bear market is still a natural product of negative growth conditions. As spending fades and revenues sputter, investment activity and rates of return are naturally depressed. The probability of another flare up in the worst financial crisis in decades is still a very real threat however. Until the leverage that was built up during the bull run from 2002 to 2007 is reduced, there will always be the potential for panic selling to overwhelm liquidity. Furthermore, over the next few weeks and months, currency traders will have to decide what is the more important potential outcome of the G10’s aggressive pace of rate cuts. Over the longer term, it may help recharge growth; but it will also stunt returns when risk appetite does finally recover. 

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Risk Indicators:	Definitions:
DailyFX Volatility Index	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.
USDJPY 25 Delta Risk Reversals 3 Month	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.
Bank of Japan Rate Expectations	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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