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Risk Appetite and Volatility for Broader Markets Temporarily Dormant not Permanently Restrained

Risk Appetite and Volatility for Broader Markets Temporarily Dormant not Permanently Restrained

2010-05-13 23:52:00
John Kicklighter, Chief Currency Strategist


• Risk Appetite and Volatility for Broader Markets Temporarily Dormant not Permanently Restrained
• Is the Next Step in the European Union Crisis the Only Catalyst for Fear?
• Expectations for Returns Continue to Climb Despite Financial Troubles, Curbed Investment

This past week was a remarkable one for the global financial markets. With concern over a European-born financial crisis building steam, strained conditions would devolve into sheer panic with a May 6th market collapse (for which the catalyst is still under debate). And, though fears have eased and assets have recovered much of the ground lost during that short-lived period of deleveraging, the taint of panic remains. The velocity and severity of the markets’ plunge has awaken the masses to a few realities that were conveniently overlooked through the preceding year. First, the backdrop for economic health and long-term investment had plateaued and perhaps has even started to deteriorate. The other truth to dawn on speculators was that returns beyond capital appreciation would be limited by a pessimistic forecasts for underlying growth – and should the steady influx of capital temper the steady advancement of assets, the outlook for quick turnover would vanish. Looking back at the jolt that finally shook the crowd out of the perception that capital markets would simply climb as they had through most of 2009, we are meet with statistics that rival true crashes like Black Monday on October 19th, 1987. The Dow Jones Industrial Average would dive nearly 1000 points in the span of a few hours. If theories that this plunge was merely the product of a few trading errors on specific blue chips, then the situation would have been isolated to a equities. However, the situation was real enough to spark remarkable volatility in commodities (gold and crude), Treasuries and especially currencies. Looking at the Carry Trade Index, the tentative push to fresh 19-month highs was swiftly met with the biggest single day drop since February of 2009. Looking more closely at the FX reaction, those currencies with the highest yield (not necessarily closest to the financial crisis) would suffer the most while the primary funding currency (the Japanese yen) would report the greatest benefit.

It is important to scrutinize the reaction of the various market’s to last week’s panic to establish just how risk is evolving. First, the rapid spread of fear from what should have been an isolated event suggests investors are anxious and highly sensitive to a definitive reversal of the good market tides that had floated most assets to fresh post-crisis highs. This suggests that the foundation of sentiment was already deteriorating beneath the market; and all that was needed was a particular catalyst to reconcile speculative expectations with sensible probabilities. The source of the market’s doubt in recent weeks is the threat of another global financial crisis building from the European Union’s struggle to fiscally reform its profligate members. The focus on this particular threat would also explain the impressive recovery after the EU announced the creation of a 750 billion euro financial rescue program aimed at preventing a default or fiscal crisis in any of the member economies. This package is remarkable; but its efficacy is questionable. Simply raising the capital will prove a challenge when those contributing are financially strapped and most are similarly over the three percent deficit-to-GDP limit. Furthermore, the economic pressure that fiscal consolidation would impart could potentially lead to double dip recessions and social unrest. Therefore, the costs of financing and the likelihood of default will further increase. In turn, there will be a stigma assigned to the sovereign debt of those countries that are already struggling, which will further increase their borrowing costs and force them to access the credit line. But, the EU situation isn’t the only threat to stable markets. Before Greece stole headlines, China’s efforts to slow its economy and markets were met with striking reactions from capital markets. This engine of optimism through the recovery could quickly return to the forefront. And, in the absence of these towering concerns, expected return is still running well above realistic value.

Is Carry Trade and risk appetite rising or falling? Discuss how to trade yields and market sentiment 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 vice versa.

We use risk reversals on USDJPY as global interest are bottoming after having fallen substantially over the past year or more. Both the US and Japanese benchmark lending rates are near zero and expected to remain there until at least the middle of 2010. This attributes level of stability to this pair's options that better allows it to follow investment trends. When Risk Reversals move to a negative extreme, it typically reflects a demand for safety of funds - an unfavorable condition for carry.





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 market prices influence 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 Reserve Bank of Australia (RBA) will make over the coming 12 months. We have chosen the RBA as the Australian dollar is one of few currencies, still considered a high yielders.

To read this chart, any positive number represents an expected firming in the Australian 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 increase and carry trades return improves.



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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