Risk reversals are the difference in volatility between similar (inexpiration and relative strike levels) FX calls and put options. Themeasurement is calculated by finding the difference between the impliedvolatility of a call with a 25 Delta and a put with a 25 Delta.
WhenRisk Reversals are skewed to the downside, it suggests volatility andtherefore demand is greater for puts than for calls   and traders are expecting the pair to fall; and visa versa. 

Weuse risk reversals on USDJPY as it is the benchmark yen pair and theJapanese currency is considered the proxy funding currency for carrytrader.   When Risk Reversals grow more extreme tothe downside, there is greater expectations for the yen to gain – anunfavorable condition for carry trades.

How are Rate Expectations calculated: 

Forecastingrate decisions is notoriously speculative, yet the market is typicallyvery efficient at predicting rate movements (and many economists andanalysts even believe the market prices influences policy decisions).To take advantage of the collective wisdom of the market in forecastingrate decisions, we will use a combination of long and short-term,risk-free interest rate assets to determine the cumulative movement theBank of Japan will make over the coming 12 months. We have chosen theBank of Japan as the yen is considered the proxy funding currency forcarry trades. To read this chart, any positivenumber represents an expected firming in the Japanese benchmark lendingrate over the coming year with each point representing one basis pointchange. When rate expectations rise, the carry differential is expectedto 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 basicknowledge of foreign exchange and interest rates differentials. Eachcurrency has a different interest rate attached to it determined partlyby policy authorities and partly by market demand.
When taking aforeign exchange position a trader holds long position one currency andshort position in another. Each day, the trader will collect theinterest on the long side of their trade and pay the interest on theshort side. If the interest rate on the purchased currency is higherthan that of the sold currency, the result is a net inflow of interest.If the sold currency’s interest rate is greater than the purchasedcurrency’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 andoutflow of yield to collect consistent income in times of lowvolatility and high risk appetite. Holding only one or two currencypairs would invite considerable idiosyncratic risk (or risk related tothose few pairs held); so traders create portfolios of various carrytrade pairs to diversify risk from any single pair and isolate exposureto demand for yield. However, even with risk diversified away from anyone pair, a carry basket is still exposed to those conditions thatrender this yield seeking strategy undesirable, such as: highvolatility, small interest rate differentials or a general aversion torisk. Therefore, the carry trade will consistently collect an interestincome, but there are still situation when the carry trade can facelarge drawdowns in certain market conditions. As such, a trader needsto decide when it is time to underweight or overweight their carrytrade exposure.

Published on  Mon, Dec 22 2008, 06:04 GMT

8589ad44-c5ff-46a7-bb37-d7265b17bc35

15

0

Fed Rate Decision And Industry Bankruptcies May Finally Tip The Balance For Risk And Carry

Mon, Dec 15 2008, 06:56 GMT
by John Kicklighter

DailyFX

Risk sentiment has delved into a period of protracted congestion over the past few months. However, with the global economy heading deeper into recession and investor/lender sentiment fading, it is only a matter of time before the markets find their bearings once again.

-Was The Dollar’s Reversal The Turn In Risk Appetite?

-The Case For Another Financial Meltdown Grows As Bailouts And Rate Cuts Fail

Risk sentiment has delved into a period of protracted congestion over the past few months. However, with the global economy heading deeper into recession and investor/lender sentiment fading, it is only a matter of time before the markets find their bearings once again. Looking at the activity in the carry index, the pattern that has formed looks very familiar. Since the November plunge ran its course, the carry basket has developed a terminal congestion formation. This wedge pattern is strikingly similar to price action in benchmark equity indexes, market yields and currency pairs with a particular correlation to risk appetite – which alone is proof that larger fundamental themes continue to direct overall investor confidence. The direction that the markets and sentiment ultimately take will be determined by fundamentals; but the bias in the market is clear. Risk appetite may have leveled off recently; but it is still hovering just above seven-year lows. What’s more, underlying condition indicators are still extremely depressed. Though improving week-over-week, currency market volatility is still at 19.5 percent. At the same time, risk reversals have barely budged from recent record lows.

What will it take to finally put the markets and sentiment back on the move? Fundamentals that have led the markets to the point have arguably worsened since congestion has set in. Through the weeks, data that has fed the global recession has leaned further into the category that the slump will be severe rather than mild. A far more pressing issue over the near-term (as investors have priced in a lot of slack for the economic deterioration) is the health of the financial markets. Bailout packages and rate cuts that have been provided to the market over the months have failed to restore lender confidence and recharge growth.
With the limits for intervention already in sight, it is clear that the problem is too large for any one policy authority to hold back the dam. In the week ahead, traders will weigh in on the potential for bailout efforts to fail and how that failure may impact the financial markets and global economy. Recently, the US Congress struck down a rescue plan for the American auto industry, which may mark the first clear jump of the credit crisis from the financial realm into the mainstream economy. Monetary policy makers are already finding their hands are tied. The Federal Reserve is expected to cut its benchmark lending rate another 75 basis points to 0.25 percent next week. While other central banks may have a little more room to work with, it is certainly not much.
Whether a breakout is at hand or not though will likely be determined by the holiday season. As is usual, liquidity is dropping into the end of the year; so a major shift in sentiment may ultimately be deferred.

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.

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.

Published on  Mon, Dec 15 2008, 06:56 GMT

bb19fd41-0d7f-4dc2-b74d-4914f3402883

1

1

Risk Appetite And Carry On The Verge Of Another Collapse

Mon, Dec 8 2008, 07:03 GMT
by John Kicklighter

DailyFX

Congestion, which has dominated price action for more than a month now, may soon give way to a renewed wave of risk aversion. As data extends the lows of the global recession, interest rates pull yields closer to zero and credit conditions seize on rising default risk, the market will draw closer to the next wave of capitulation and deleveraging.

• Risk Appetite And Carry On The Verge Of Another Collapse

• The Global Economy’s Plunge Into Recession May Revive Panic

• How Will International Yields’ Drive Towards Zero Impact The Eventual Rebound?

Congestion, which has dominated price action for more than a month now, may soon give way to a renewed wave of risk aversion. As data extends the lows of the global recession, interest rates pull yields closer to zero and credit conditions seize on rising default risk, the market will draw closer to the next wave of capitulation and deleveraging. These fundamental influences are clearly read through the activity of the carry trade. Both the dollar and Japanese yen crosses have edged closer to their respective breaking points, while the DailyFX Carry Trade Index is closing in on the seven-year low set in late October at the tail-end of the panic selling that proliferated during that month. This bearish shift in sentiment has not been surprising, rather carry and risky positions have gradually moved lower after a volatile relief reversal. Such a consistent and steady decline is far more suggestive of the strength of the dominant bear trend. What’s more, market condition indicators never truly recovered from readings that suggested risk aversion was the overriding theme for the markets - further suggesting the rebound in prices was merely a brief rally after a temporary trend exhaustion. Volatility in the currency market is still above 20 percent (versus 7 percent a year ago) and risk reversals held near recent historical lows.

Fundamentally, risk appetite has not changed much over the past few months from the fear that first began to drive the markets lower. And, if anything, conditions have actually gotten worse. In October, the plunge in carry (and risk in general) was the culmination of growing default risk, a full seizure in international lending conditions and a round of indicators that confirmed the economic slump that began in the US was global as well as severe. In other words, this ‘perfect storm’ of sorts merely accelerated what was already underlying the market and forced a rush for the exit. Stimulus packages, guaranteed liquidity on short-term funds and bailouts aimed at the financial sector have helped to curb the panic; but left are the true drivers for a natural bear market. Data and events this past week have merely confirmed that the scales of risk and reward are still heavily skewed towards trouble ahead. From the worlds’ largest economy, the National Board of Economic Research (NBER) confirmed the United States has been in a recession since December of 2007, while non-farm payrolls reported more than a half million lost jobs through November to suggest the slump may be the worst the worst since World War II. The sentiment from other industrialized economies is similar. Ultimately, such concerns could be offset if the reward from investing compensated for risk; but another broad range of rate cuts (ECB, BoE, RBA and RBNZ) has left anemic yields.

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:

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.

Published on  Mon, Dec 8 2008, 07:03 GMT

d9b5211b-9130-4f95-b4ed-f5a839fee153

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0

Rate Decisions And Bailout Details May Help Determine Risk Appetite And Carry Trade Trends

Mon, Dec 1 2008, 06:18 GMT
by John Kicklighter

DailyFX

The long holiday weekend for the US markets has clearly curbed activity in the dollar and to some degree the entire currency market. However, for all intents and purposes, caution is still the primary sentiment for risk trends and the carry trade.

• Rate Decisions And Bailout Details May Help Determine Risk Appetite And Carry Trade Trends

• Fed Aims Its Stimulus At Housing And Consumers, EU Drafts A Package Of Its Own

• When Will Interest Rates Be A Carry Trade Driver Again?

The long holiday weekend for the US markets has clearly curbed activity in the dollar and to some degree the entire currency market. However, for all intents and purposes, caution is still the primary sentiment for risk trends and the carry trade. Now, looking ahead to next week, the market will have to weigh the effectiveness of ever-growing stimulus packages against the overwhelming influence of a global recession and universal interest rate cuts. Taking stock of where sentiment will go, we first need to gauge the health of the carry trade. We can see from the DailyFX Carry Trade Basket, that carry interest has improved modestly from last week; but a quick look to the past shows, that the basket is still near the very bottom of the strategy’s six-year range. Furthermore, the fact that there is little effort being made to capitalize on the sidelined momentum from last month’s relief rally suggests there is little interest in trying to collect yield when market volatility is keeping the cost of carry very high. In fact, the DailyFX Volatility Index (a composite of implied volatility from three-month options on six of the majors) is still above 20 percent – more than three times greater than the average level of forecasted activity a year ago. More promising is the rebound in risk reversals, which suggests speculative interest is easing its bearish pressure.

Direction and volatility have settled somewhat over the past week due more to liquidity conditions throughout the markets than any real shift in risk appetite. When the market fills out next week the same, major fundamental themes will be at play once again. The stability of the financial markets and health of global growth will be of primary importance. Focus will turn to the US equity markets which have enjoyed their strongest drive since 2001after rebounding from a six-year low. Should this reversal prove to be a genuine trend change, it will be a major step towards reviving risk appetite. More than likely though, the relief in selling pressure was probably just that – a temporary break. A tolerance for risk and demand for yield would have to find a solid foundation in growth to flourish. However, the outlook for the global economy is pointing to recession even through the most conservative estimates. Next week, a few major industrialized nations will offer first and second readings on economic activity.
Expectations are relatively optimistic, so the potential for surprise is substantial. Another direct influence on the carry trade (and the counterpoint to risk appetite) could be changes to key interest rates. The European Central Bank, Bank of England, Reserve Bank of Australian and Reserve Bank of New Zealand are all expected to cut rates next week. Finally, the markets will continue to weigh their confidence in ever-expanding, national bailouts.

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.

Published on  Mon, Dec 1 2008, 06:18 GMT

a30a6944-f03d-487d-beeb-51bda19ae169

13

0

Risk Appetite, Carry Interest Unstable As Bailout Efforts Are Overwhelmed By Fear And Recession

Mon, Nov 24 2008, 06:37 GMT
by John Kicklighter

DailyFX

Current market conditions are somewhat deceiving. Volatility has edged back and the currency market’s most liquid pairs are entrenched in long-term congestion. However, the atmosphere is ripe for an impending breakout that will soon revive a singular trend for risk aversion and the carry trade.

• Risk Appetite, Carry Interest Unstable As Bailout Efforts Are Overwhelmed By Fear And Recession

• Congestion Across Currency Market Backed By Rising Volatility Points To Imminent Breakouts

• Are Traders And Investors Still Too Optimistic On Growth And Financial Market Conditions?

Current market conditions are somewhat deceiving. Volatility has edged back and the currency market’s most liquid pairs are entrenched in long-term congestion. However, the atmosphere is ripe for an impending breakout that will soon revive a singular trend for risk aversion and the carry trade. The back and forth in general sentiment has been clearly reflected through the consolidation seen in the DailyFX Carry Trade index over the past month – a period of reflection after the crisis-state the markets were in through most of October. However, despite this hesitation, the index has steadily found its way back on track with the dominant trend, nearly retracing the entire rebound at the turn of the month. This suggests the recovery was merely a temporary relief rally that reduced the pressure on the market from potentially over-extended levels. Furthermore, signs like the excessively high levels of volatility in the currency market and the steady build up in interest for bearish yen cross options stand as warnings to the market that there is still significant pressure behind risk trends; and such conditions are not typically associated to reversals but rather continuation.

Over the past four weeks, the markets have turned to consolidation as panic unwinding of risky positions and the frantic flight to safety has tapered off. However, fundamental conditions have certainly not improved since the October drive. In fact, there is debate in the market whether the situation has actually grown worse. As of yet there is no consensus; and this has allowed general sentiment to take on a greater role over market activity than true fundamentals. With momentum finally stumbling, those traders that were short risk saw the opportunity to book profit and capital that was divested during the panic could find its way back into a more orderly market. Nonetheless, even after the strong trend had been reined in, volatility sustained exceptionally high levels and the bearish bias of the past four months was gradually revived. With sentiment extremes curbed, the focus can turn back to the speculation over growth and the health of the financial market to gauge risk and the next phase of the carry trade trend. News and events this past week suggest there are still difficult times ahead. The EU announced the need for a regional bailout package, the SNB was forced to cut their primary lending rate 100bps, and credit risks hit fresh records as the benchmark US equities markets pushed six year lows. More concerning though is the potential failure of US auto manufacturers - a sign that trouble is now on Main Street and not everyone will be saved.

Do you think risk sentiment and carry will rebound? Join the DailyFX analysts in discussing the health of risk appetite 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.

Published on  Mon, Nov 24 2008, 06:37 GMT

e54b5eca-c658-4b87-a9dd-d0dd0d7b79bd

13

0

A Tentative Rebound In Risk Appetite Starting To Unsettle Congestion, Boost The Dollar And Yen

Mon, Nov 17 2008, 05:51 GMT
by John Kicklighter

DailyFX

Though congestion took over for the currency market through the first half of this month, volatility continued to rise. Now, with risk aversion once again on the rise, the pent up pressure behind the market threatens significant breakouts and the revival of the most aggressive selloff in decades.

• A Tentative Rebound In Risk Appetite Starting To Unsettle Congestion, Boost The Dollar And Yen

• Treasury Cuts Plans To Buy Troubled Asset Back Securities In Favor Of Taking Equity Stakes

• Volatility Continues To Rise As Bigger Leverage And Economic Issues Direct Market

Though congestion took over for the currency market through the first half of this month, volatility continued to rise. Now, with risk aversion once again on the rise, the pent up pressure behind the market threatens significant breakouts and the revival of the most aggressive selloff in decades. Using the carry trade as a barometer for the risk appetite, we can see the markets have already taken the first steps towards restoring the momentum to the now-dominate trend. After peaking last week, the index has marked a sharp reversal, tumbling 775 points to 21,310. To really engage the market though, October’s 19,739 low will need to give way to catalyze panic that has sent investors rushing for the exits in the past (which in turn squeezed liquidity and thereby accelerated the decline). All the significant market conditions are aligned for another crash-like plunge. Aside from the primary drivers of a global recession and need to work off over-leveraged positions, underlying volatility is still four-times its average reading between 2002-2007 – and rising. What’s more, options reveals cautious investors have driven risk reversals to new record (going back 5 years) lows.

As expected, the rebound that we have seen in carry interest and risk appetite through the opening weeks of this month were short-lived. Such aggressive moves, like the one that has developed since August in either direction rarely come without a relief retracement that reestablishes the opposite side of the market. Now, after short-sellers have taken profit and the world’s policy makers have issued their aggressive bailout plans, investors will once again have to turn to the fundamentals behind the market’s futures. Through the medium-term, the global economy is heading for its worst recession in decades. So far, we have merely seen confirmation that the European community has entered a technical recession; but considering the deterioration of data over the past few months (especially in regards to consumer spending), the outlook for the economic activity looks vastly worse. The more pressing issue through the immediate future, however, will be the health of the financial markets. Large bailout packages, near-unlimited access to short-term liquidity and coordinated rate cutes seemed to have brought back some confidence in the basic functioning of markets. On the other hand, recessions bring bear markets and the market is still floating on leverage and credit. All of this must be worked through.

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.

Published on  Mon, Nov 17 2008, 05:51 GMT

452f17fe-77e7-4e96-bfa5-c286524937d8

11

0

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

Mon, Nov 10 2008, 06:51 GMT
by John Kicklighter

DailyFX

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.

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:

DailyFX Volatility Index

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.

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.

Published on  Mon, Nov 10 2008, 06:51 GMT

2f79ba28-8df8-49a3-a836-418c2297f36d

31

0

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

Mon, Nov 3 2008, 06:36 GMT
by John Kicklighter

DailyFX

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.

Published on  Mon, Nov 3 2008, 06:36 GMT

2530c416-a730-4af3-9a32-a42d04e0432b

27

0

Risk Appetite And Carry Trade Hammered As Investors Deleverage And Recession Approaches

Mon, Oct 27 2008, 06:21 GMT
by John Kicklighter

DailyFX

Despite coordinated interest rate cuts, guarantees on lending, and governments drawing bad doubt of the world’s largest economies, panic continues to flare up in the world’s financial markets. With risk appetite hitting new lows, it is starting to dawn on market participants and officials over-leveraged markets and an oncoming recession cannot be averted by government intervention.

• Risk Appetite And Carry Trade Hammered As Investors Deleverage And Recession Approaches

• Hitting Extremes This Week, The Carry Trade Fell To A Five Year Low While Volatility Hit A Record High

• Can The Government Intervention Prevent A Natural Recession?

Despite coordinated interest rate cuts, guarantees on lending, and governments drawing bad doubt of the world’s largest economies, panic continues to flare up in the world’s financial markets. With risk appetite hitting new lows, it is starting to dawn on market participants and officials over-leveraged markets and an oncoming recession cannot be averted by government intervention. Friday’s sharp decline ended the most recent leg of an ever-evolving unwinding of the carry trade. The DailyFX Carry Trade Basket dropped a staggering 12.9 percent through the week to a new five-year low 20,459. Altogether, this once prevalent Forex strategy has plunged nearly 37 percent since its peak last summer. What’s more, market conditions suggest the outlook doesn’t promise a return to risk appetite anytime soon. Implied volatility – a measure of intensity for the declines – surged five percentage points to 20.6 percent. Equally concerning, put premiums have soared for USDJPY with risk reversals dropping to -9.62 percent. And, further ensuing the ultimate rebound will be that much more difficult to achieve, even the BoJ is expected to join the global effort to ease lending rates.

Risk appetite is in full retreat and the carry trade is tracking its evaporation step-for-step. At this point, we need to discern whether this is a move of panic or one that is more deeply rooted in fundamentals. As we can see from the last few implosions in carry and broader risk sentiment (in which there was no specific driver like bank failures a few months ago), the answer is both.
Fear is arising from a market that is struggling to unload risky positions with liquidity virtually absent. When one regional market experiences a sharp sell off, it now encircles the globe with an amplified finish in the major financial centers. Under normal circumstances, such distressed levels would usually encourage the other side of the market to quickly return to the market.
However, this isn’t a normal situation. Aside from the attempts to avoid the next market crash, investors, banks and lenders are genuinely trying to reduce the leverage built up through the boom years of 2002 through 2007. Further increasing the sense of urgency to reduce exposure to tumbling markets is the onset of a global recession. The UK confirmed its worst slump in nearly 18 years and the US is expected to keep the ball rolling to an eventual global recession. Can the world’s governments artificially hold leverage and growth up? No. And so the markets will continue to fall.

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:

DailyFX Volatility Index

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.

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.

Published on  Mon, Oct 27 2008, 06:21 GMT

1135805d-f04b-4b78-945c-f18d71b9d660

0

0

Carry Rebounds On Improved Risk Appetite And Volatility, But Will The Calm Last?

Mon, Oct 20 2008, 06:15 GMT
by John Kicklighter

DailyFX

• Carry Rebounds On Improved Risk Appetite And Volatility, But Will The Calm Last?

• Investor And Lending Panic Abates, Yet Credit Collapse And Recession Far From Spent

• Are These The Right Conditions To Return To A Lower Yield, Higher Risk Carry Strategy?

Though price action settled into the weekend, traders shouldn’t be lulled into thinking that fear has been exercised and risk appetite will lead to an immediate turn in the carry trade. With credit markets still working off excess leverage and diminishing interest rates reducing returns, the outlook for carry and all other high-risk strategies is still bleak. If we were judging conditions by the past week alone, it may indeed seem as if risk appetite had turned. The DailyFX Carry Trade Index surged 825 points to 23,133. This was the first improvement in four weeks and helped to take some of the pressure of the last week’s sharp decline – the biggest in at least 15 years. What’s more, volatility (one of the best gauges of fear for any market) dropped an incredible 3.3 percent. However, when we look at the bigger picture, we can see that these were relatively modest improvements in a broader collapse in risk appetite. While the carry index experience a significant recover, it remains just off of five-year lows. What’s more, volatility of 15.8 percent in the currency market is nearly three times the level of expected activity back in the first half of 2007 – when the carry trade was still near its peak.

It may be tempting to call the bottom in the carry unwind; but the critical fundamental questions that have to be asked to qualify such speculation do not support the recovery of a strategy that requires low volatility and abundant return. To begin with, risk is still lingering in the market. Not only is volatility high for currencies, it is high for equities, commodities and many other asset classes. Indeed, it will take considerable time before caution gives way to unencumbered speculation considering the crash markets suffered so far this month. What’s more, the source of the worst rout since the Great Depression is still hanging over lending and investment trends: credit. Though the governments of the world’s largest economies conducted coordinated rate cuts, guaranteed lending and put up massive amounts of money to draw the toxic debt out of the market, this cumulative effort means little to a $55 trillion credit derivatives market. With banks, investors and lenders still extremely overleveraged through credit, the markets can easily overwhelm rescue efforts. What’s more, even if credit were not an issue, the fact that the global economy is heading into a recession and rates are dropping would be.

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:

DailyFX Volatility Index

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.

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.

Published on  Mon, Oct 20 2008, 06:15 GMT

1c515283-afea-41e7-b38c-79a97622e2ec

0

0

Worst Market Crash In Recent History Sends Risk Appetite And Carry Plummeting

Mon, Oct 13 2008, 10:49 GMT
by John Kicklighter

DailyFX

It is difficult for anyone to miss the massive wave of risk aversion that has washed over the global markets these past two weeks. With basic lending and borrowing (the lifeblood of the financial system) frozen by oppressively high rates, the markets are being held hostage by sentiment; and until pessimism eases, the risk-related assets will maintain their bearish trajectories.

• Worst Market Crash In Recent History Sends Risk Appetite And Carry Plummeting

• DailyFX Carry Trade Index Near Five Year Low As Volatility Indicator Hits Recent Record High

• Is This Irrational Exuberance And What Can Cure It?

It is difficult for anyone to miss the massive wave of risk aversion that has washed over the global markets these past two weeks. With basic lending and borrowing (the lifeblood of the financial system) frozen by oppressively high rates, the markets are being held hostage by sentiment; and until pessimism eases, the risk-related assets will maintain their bearish trajectories. For the currency market, the best measure for fear is the carry trade. Today, the DailyFX Carry Index dropped to 22,444 – its lowest level in five since the final months of 2003. Far more concerning though is the accelerated rate of the decline. Since the peak back in the summer of last year, the basket has dropped 30 percent; but in just the past week, it has dropped 12 percent.
Such an aggressive drop is pure panic, and other market condition indicators confirm the environment. Risk reversals have shown a dramatic increase in put premiums while the DailyFX Volatility Index has ballooned to an unheard of 18.7 percent. These conditions can’t last forever, but they can get worse.

While forecasts for a global recession is a significant burden on the appetite for risk, the true root of this market panic is credit. Since the rebound in investment trends after the Dot-Com bubble, businesses, consumers and investors leveraged themselves through credit. After the long build up, the house of cards first started to collapse with the sub-prime mortgage market. Mortgage rate adjustments led to defaults which then exposed the massive leverage built up in credit derivatives. What’s happening now is the rapid unwinding of this built up leverage. This is an essential step to putting the global markets and economy back on an even keel; but the fear that has accompanied the move has concentrated the pain rather than allowing conditions to deflate in an orderly economic down turn. Ongoing efforts by policy officials to stem the bleeding have done next to nothing to stop the tide. The coordinated rate cut earlier this week has (not surprisingly) failed to encourage investment when banks are struggling to move depressed assets off their books. Both the US and UK bailout plans are promising as longer-term fixes, but they are weeks away from actually drawing the bad debt from the markets. Looking ahead, this weekend’s G7 meeting may see additional rate cuts; but the Fed’s planned CDS clearinghouse holds true potential.

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.

Published on  Mon, Oct 13 2008, 10:49 GMT

c70ff3e6-8908-4d69-847c-e8a90c11c981

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Risk Appetite And Carry Trade Find Little Relief In Bailout Approval

Mon, Oct 6 2008, 09:07 GMT
by John Kicklighter

DailyFX

While volatility surged across the markets after the US House of Representatives shot down the first vote on the $700 billion bailout plan this past Monday, the successful second attempt on Friday found a far more muted response.

• Risk Appetite And Carry Trade Find Little Relief In Bailout Approval

• Are Europe And The UK Heading For Financial Crises Of Their Own?

• Market Shifts From High Risk On Credit Crisis To Low Returns With Recession

While volatility surged across the markets after the US House of Representatives shot down the first vote on the $700 billion bailout plan this past Monday, the successful second attempt on Friday found a far more muted response. Looking beyond the short-term implications of this immediate event risk, risk appetite continues to plunge. Over the past week, the DailyFX Carry Trade Index plunged 1,056 points to 25,429. While there is some precedence for support back in June of 2006, the popular strategy has notably tested lows this week not seen since January of 2005. What’s more, taking a closer look at market condition indicators, it seems that fears are growing rather despite policy makers’ efforts to revive confidence in the credit market. The DailyFX Volatility Index has surged to new highs above 14 percent – levels not seen in over 10 years. What’s more, risk reversals show options traders continue to bid up protective puts as the declines in yen crosses and other popular carry-pairs gain momentum.

Heading into Friday’s Congressional vote on the rescue bill, many policy officials and market participants were hopeful that mere confirmation of the US government’s help would revive confidence. However, the response to this report shows that fundamentals have perhaps deteriorated to such a point that a bailout state-side will not be enough to stop the tide of a global financial crisis. Indeed over this past week, a debate arouse between the French and German government over the need for a European bailout. While growth numbers were already contracting and high lending rates were inflicting pain in the regional community, it took a series of emergency rescues (Hypo Real Estate, Fortis and Dexia) to prompt a serious assessment of the problem. Essentially, the market may have reached a point where the removal of toxic debt from American banks and lenders may not be enough to revive confidence in counter-party risk and stabilize lending rates. If that proves true, nothing short of a global effort may be enough to rehabilitate lending and investment. What’s more, even if risk fades, momentum is building behind a global economic slowdown. This means the imbalance of fear is merely swapped for depressed returns that cannot compensate for the lingering trepidation in the market.

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.

Published on  Mon, Oct 6 2008, 09:07 GMT

cafcc2da-8345-43e8-9f84-58c27be5d6ba

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Risk Appetite And Carry Frozen As Financial Crisis Evolves While Congress Debates

Mon, Sep 29 2008, 13:25 GMT
by John Kicklighter

DailyFX

The long-term health of the credit and financial markets hangs in the balance; and while the US bailout plan is debated in the nation’s capital, risk sentiment and the carry trade continue to fade.

• Risk Appetite And Carry Frozen As Financial Crisis Evolves While Congress Debates

• Would The Carry Trade Rebound Even If A US Bailout Is Agreed Upon?

• Where Financial Turmoil Ends, Recessions And Rate Cuts Begin

The long-term health of the credit and financial markets hangs in the balance; and while the US bailout plan is debated in the nation’s capital, risk sentiment and the carry trade continue to fade. Indeed, while market conditions may seem better than last week when the panic was freezing liquidity, traders’ patience is quickly wearing thin as global central banks are still forced to inject short-term liquidity and major banks are failing while the US government’s rescue plan is held up by politics. Since the initial relief found when Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke proposed their $700 billion bailout, the DailyFX Carry Trade Index has fallen back from its temporary highs. Through Friday, the index was 147 points of last week’s levels at 26,520. Suggesting the market has remained skeptical throughout the past two weeks, condition indicators skipped the relief reflected in price. The DailyFX Volatility Index has advanced back to 13 percent while risk reversals have tumbled to 6 month lows.

Market participants are hesitant to take a position on direction – especially when it involves a risk-leveraged carry trade. While there are options on the table to help lift the US financial markets out of its downward spiral, the outlook for risk appetite is bleak regardless of when the plan goes through and what details it may come with. In the short-term, the longer the bailout is delayed, the greater the risk that the market will deteriorate into another panic state and the higher the probability that the banking sector will suffer further bankruptcies (we have already seen Washington Mutual go under). However, even if an agreement is reached, the market will still need to evaluate whether or not the effort can truly right a global problem with credit conditions and investor sentiment. Should the funds made available to the Treasury and Fed be too little, they wouldn’t be able to draw enough of the toxic debt out of the market to prevent ongoing write downs. What’s more, looking beyond this crisis, even if the financial markets begin to function properly, there is still a global downturn in growth to deal with. The drop in interest rate and investor sentiment that would no doubt follow this cooling in activity merely casts the carry trade in a poor light regardless of the effort made in the next few days and weeks.

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.

Related Articles:

- Forecasts of a recession in the second half of the year may be on the backburner for traders but not for the Fed.

- Bank failures and ongoing financial market instability leads to unusual trading condtions for the currency market.

Published on  Mon, Sep 29 2008, 13:25 GMT

8a1cc519-e494-4875-9686-6c1e22dbe042

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Risk Appetite And Carry Interest Find Sharp Rebound On Fed Policy Announcements

Tue, Sep 23 2008, 11:37 GMT
by John Kicklighter

DailyFX

It has been a volatile week for risk appetite as the markets have swung from full blown panic to record breaking relief rallies in the span of five days. Acting as a barometer for the dramatic shift, the DailyFX Carry Trade Index had plunged to fresh two-year lows and before rallying over 900 points to close the week in the green.

• Risk Appetite And Carry Interest Find Sharp Rebound On Fed Policy Announcements

• Traders Wonder, Are There Any More Financial Sector Failures On The Horizon

• Global Interest Rate Forecasts Still Constricting Potential Carry Return

It has been a volatile week for risk appetite as the markets have swung from full blown panic to record breaking relief rallies in the span of five days. Acting as a barometer for the dramatic shift, the DailyFX Carry Trade Index had plunged to fresh two-year lows and before rallying over 900 points to close the week higher. However, while the carry trade and sentiment seem to have improved from their worst levels of this past week, it is not reasonable to assume that the markets have turned the longer-term bearish trend surrounding risky assets. Taking a step back and looking more objectively at the level of the carry trade and market condition indicators, its obvious that it wouldn’t take much to trigger another crippling flight to safety. With the carry trade index just off multi-year lows, premium for puts at six month highs and the DailyFX volatility index pulling back from 13.2 percent, conditions are still very tense.

Like the price action in the carry-trade pairs, the fundamentals underlying the currency moves has moved from one extreme to the other this past week. When liquidity returned to the market last Monday, the first shock was delivered by the Lehman Brothers collapse. There was good reason to believe the central bank would move in to bail out the once-third largest securities firm as the potential for a market crisis was much greater with this situation than it was with Bear Stearns. When it was obvious that the government was no longer a support net for public entities, fear set in. Genuine panic hit the market when speculation that AIG (one of the world’s largest insurers) would go under. This consequences of this firm going under would be far more dire for the world’s financial system and the market knew it. A liquidity crisis spurred the Fed to enlist the world’s largest central banks to auction record amounts of short-term dollar funds into the system; however, the effort didn’t stop there. Recognizing the potential for disaster and need for substantive change rather than quick fixes, the Fed confirmed speculation that it would develop a financial solution to move illiquid assets off bank’s balance sheets and to insure money market funds. The promises have gone a long way to soothe immediate fears, but can this truly revive the carry trade? Though risk has settled, fading growth and investment trends will continue to squeeze yields (returns).

Risk Indicators:

DailyFX Volatility Index

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.

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.

Published on  Tue, Sep 23 2008, 11:37 GMT

7e5d8b9c-117c-4dd4-bfcb-9bdea48aa3d0

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Carry Trade Interest Rebounds On Speculation Of Lehman Brothers Buyout

Mon, Sep 15 2008, 06:20 GMT
by John Kicklighter

DailyFX

The DailyFX Carry Trade Index marked a sharp rebound (evident in many of the yen crosses) through Friday’s close, but not before dropping to its lowest level since July 11th, 2006. This is a situation were strength is based on precarious elements at best. A genuine recovery in risk appetite will require a tangible improvement in the outlook for the financial sector and economic activity.

• Carry Trade Interest Rebounds On Speculation Of Lehman Brothers Buyout

• With Risk Still Very High And Returns Fading, Can A Rebound Be Sustained?

• Where Do Expectations Of A Cooling Global Economy Fit Into The Carry Rebound?

The DailyFX Carry Trade Index marked a sharp rebound (evident in many of the yen crosses) through Friday’s close, but not before dropping to its lowest level since July 11th, 2006. This is a situation were strength is based on precarious elements at best. A genuine recovery in risk appetite will require a tangible improvement in the outlook for the financial sector and economic activity. By the close of the week, the Carry Trade Index stood at 26,534 for an actual improvement over last Friday’s close of 165 points. However, a more objective look at carry cuts optimism short. The entire improvement through the past week was based on a late 540-point rebound from the new two-year low. What’s more, market condition indicators have done little to bolster expectations of a true trend change. Risk reversals are still trending in favor of bearish puts; but more worrisome is the level of volatility in the currency market. The DailyFX Volatility Index is well above 11 percent and pushing highs not seen since regulators were sorting out the Bear Stearns mess.

The fundamentals underlying the popular yield strategy look a lot like the technicals of the index. With risk appetite drudging new lows and the outlook for returns shrinking, the market was primed for any sign of improvement. The spark for a rebound came from news and speculation of bailouts. After a plan was drafted over the weekend, the Treasury Department took the helm for the quickly sinking Freddie Mac and Fannie Mae. However, even though this rescue secured over $5 trillion in debt; the market was clearly focused on other problems. Instead, the much more precarious health of Lehman Brothers was starting to resemble the collapse of Bear Stearns (Fannie and Freddie were already relatively secure as government sponsored enterprises). Going into the end of the week, the fate of the number three securities firm was still up in the air with rumors emerging that a consortium was interested but that the government would not facilitate a purchase. If Lehman is bought, it would likely give short-term momentum to the carry rebound. However, looking beyond this averted financial crisis, there is a long list of banks on the Fed watch list and global growth is cooling. What’s more, with the RBA and RBNZ cutting rates (the latter by 50 bps this week), the reward for taking such risky exposure may not balance anymore.

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:

DailyFX Volatility Index

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.

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.

Published on  Mon, Sep 15 2008, 06:20 GMT

890632d8-7d94-4a9f-93f5-b7e9a8e35f32

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0

The Carry Trade Plummets To Two Year Lows As Risk Appetite And Yields Shrivel

Mon, Sep 8 2008, 08:30 GMT
by John Kicklighter

DailyFX

The health of the carry trade is dependant on a foundation of high returns (wide yield differentials) and low volatility (or perceived risk). Considering the outlook for global interest rates has plunged over the past weeks and broad fears are growing out of a global slowdown in growth and lingering threats to the financial system, it makes sense that the carry trade has tumbled recently.

• The Carry Trade Plummets To Two Year Lows As Risk Appetite And Yields Shrivel

• Momentum Building In Carry Unwinding With DailyFX Carry Index Down 1,284 Points

• Market Condition Indicators Slow To Pick Up On The Panic Selling

The health of the carry trade is dependant on a foundation of high returns (wide yield differentials) and low volatility (or perceived risk). Considering the outlook for global interest rates has plunged over the past weeks and broad fears are growing out of a global slowdown in growth and lingering threats to the financial system, it makes sense that the carry trade has tumbled recently. With the high yielders on the retreat and capital finding its way back into funding currencies like the Japanese yen and Swiss franc, the DailyFX Carry Trade Index has collapsed this past week by losing another 1,284 points. This incredible move has brought the total decline from the mid-July swing high to 2,933 points and led the index to its lowest level since May 2006. On the other hand, while it is clear that aggressive and panic selling is dominating the market, market condition indicators haven’t really caught up to drop in price. Risk reversals slipped 0.74 percentage points, but are only at two-month lows. At the same time the broad currency volatility has barely tested its range high.

Technically, there doesn’t seem to be a valid floor to stem the losses for the carry unwinding in either the individual risk-sensitive currency pairs or in the aggregate index. This seems to suit the fundamental facet of this decline well. Scanning the economic data and news over the past few weeks, there doesn’t seem to have been any specific triggers that would set off such an overwhelming flight from risk. However, the pressure has certainly been building up with time. Concern over risk (volatility) has been consistently stoked by speculation that the failure of a major financial institution would send global markets into turmoil. So far, the highest probability targets are a Freddie Mac/Fannie Mae combo or Lehman Brothers. With the failure rate among US banks at its highest level in 14 years, a bank collapse will remain an imminent treat. For the GSE’s a sizable sum of debt is due to mature in later this month, which should test their capitalization and the market’s tolerance. The newer (and perhaps more catalyzing) concern is the sharp reduction in expected returns. Both the RBA and RNBZ have cut their rates and signaled further easing down the line. With the market expecting the ECB, BoE and Fed expecting to follow suit later on, the yield differentials on the most liquid carry trade pairs simply can’t compensate for risk.

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:

DailyFX Volatility Index

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.

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.

Published on  Mon, Sep 8 2008, 08:30 GMT

815ddafe-854c-41cb-8f82-a610361efe95

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Carry Unwinding Continues While Rate Decisions Look To Further Stoke Volatility

Mon, Sep 1 2008, 08:36 GMT
by John Kicklighter

DailyFX

Interest rate expectations will play a pivotal role in the overall health of the carry trade next week as four G10 central banks are scheduled to deliver monetary policy decisions. It’s this high level of event risk on the horizon that shines a bright spotlight on the precarious position the popular Forex strategy.

• Carry Unwinding Continues While Rate Decisions Look To Further Stoke Volatility
  

• Only One If Four Central Banks Is Expected To Shift, But Will Commentary Shift Rate Forecasts?
  

• Market Condition Indicators Slipping As USDJPY Threatens To Follow The Yen Crosses

Interest rate expectations will play a pivotal role in the overall health of the carry trade next week as four G10 central banks are scheduled to deliver monetary policy decisions. It’s this high level of event risk on the horizon that shines a bright spotlight on the precarious position the popular Forex strategy. Over the past week, a drop in forecasted yield differentials (and to a lesser extent risk considerations) revived the decline in the DailyFX Carry Trade Index. Now hovering just above a five-month low, the carry trade stands on the cusp of a major trendline. Should the outlook for returns and risk push the index to a breakdown, it could very well recharge the choppy downtrend from last summer’s reversal and develop a momentum in the carry unwinding that has been otherwise missing over the past year. On the other hand, while an aggressive unwinding seems to already be underway, market condition have been relatively constrained. FX volatility is just above 10 percent and risk reversals are no where near past month lows.

Over the past few weeks, the carry trade has been under constant pressures from looming risk considerations and quickly fading rate expectations. From the risk side of the equation, the threat of another global credit crunch has kept all markets on alert.
The two most visible risks for the strategy that relies on low volatility: an imminent bailout of Freddie Mac and Fannie Mae and the potential for another major US bank to collapse. The two US GSEs (government sponsored entities) hold an estimated 50 percent of the nation’s mortgages. Should the US government be forced to take the reins on the two, rates will likely jump as the market factors in risk premiums and policy officials try to curb additional lending. In the other scenario, America’s financial leaders have reported massive write downs, have broken up their businesses and have recently been burdened with buying back auction rate debt sold to clients. Just like with the Bear Stearns debacle, a collapse would send all debt holders running for the exits. However, while these issues have been simmering in the background, next week’s rate decisions will offer an immediate impact on carry. The two top carry currency central banks (RBA and RBNZ) are expected to decided rates; and the Australian authority is expected to cut for the first time in seven years.

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:

DailyFX Volatility Index

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.

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.

Published on  Mon, Sep 1 2008, 08:36 GMT

7a8ec04e-d407-40d3-86ad-95fa286d9ab2

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Dollar Rally And Crude Pull Back Salvages A Carry Collapse

Mon, Aug 25 2008, 06:03 GMT
by John Kicklighter

DailyFX

The late rebound in the US dollar and sharp pull back in volatile crude helped revive the ailing carry trade this past week.
However, considering the deteriorating outlook for the US financial system and the fading yield outlook, it may be difficult to sustain the fickle market conditions needed for the carry trade to prosper.

• Dollar Rally And Crude Pull Back Salvages A Carry Collapse
  

• Can Risk Appetite Continue To Rise With Freddie, Fannie And Lehman Facing Collapse?
  

• Rate Forecasts Continue To Cut Into Returns Regardless Of Risk

The late rebound in the US dollar and sharp pull back in volatile crude helped revive the ailing carry trade this past week.
However, considering the deteriorating outlook for the US financial system and the fading yield outlook, it may be difficult to sustain the fickle market conditions needed for the carry trade to prosper. With the week’s rebound, the DailyFX Carry Trade Index rose 120 points (less than 15 percent of the steep reversal from July 22nd). However, while the bounce has been slow to gain ground, market conditions have benefited from the reduced momentum and volatility. The DailyFX Volatility Index fell 0.3 percentage points to 10 percent as many of the majors settled back towards major dollar-resistance levels. What’s more, risk reversals for the proxy carry pair (USDJPY) show traders are once again paying a higher premium for directional calls and less for protective puts – an indication of risk and direction.

It shouldn’t be a surprise that the rebound in the carry trade has proceeded rather cautiously. Fundamentals surrounding the appetite for yield and aversion to risk have clearly shrouding the future of the global financial sector in a disappointing light. The top headlines over the past week show a market that is growing increasingly fearful of another major financial collapse on the level of Bear Stearns. Further whipping up speculation that such an event was inevitable, the former head of the IMF forecasted that at least one major American bank would go under within the year. So, who could end up take such an nefarious title? The candidate pool is deep. Citi recently recently downgraded its profit outlook for Goldman Sachs, Lehman Brother and Morgan Stanley (and many others are joining the list with forced buy backs of auction rate debt adding to already damaging write downs). However, there are a number of banks that are on a watch list, many analysts and market participants see a particular set of banks circling the drain. Freddie Mac and Fannie Mae debt yields jump to its highest level since 1986 while its preferred shares were slashed to the lowest investment grade. Elsewhere, Lehman brothers is holding an estimated $75 billion in hard to sell assets and failed to move 50% of a share offer in Asian.

Risk Indicators:

DailyFX Volatility Index

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.

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.

Published on  Mon, Aug 25 2008, 06:03 GMT

5ab1ddbf-7900-4896-8840-1e4569ac87a2

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Carry Trade Plunges, But Yen Pairs Testing Support

Mon, Aug 18 2008, 06:35 GMT
by Daily FX Research Team

DailyFX

While the dollar’s ongoing rally has grabbed most headlines, the market seems to be catching on to the other big trend in currencies: the distinct breakdown in the carry trade. The deterioration in the yield-based strategy is partially rooted in a rise in risk aversion; but warped risk / reward is likely the greater driver for the recently volatile FX market.

• Carry Trade Plunges, But Yen Pairs Testing Support

• Interest Rate Expectations Grow Increasingly Skewed

• Currency Market Volatility Rebounds As Carry Pairs Lose Direction

While the dollar’s ongoing rally has grabbed most headlines, the market seems to be catching on to the other big trend in currencies: the distinct breakdown in the carry trade. The deterioration in the yield-based strategy is partially rooted in a rise in risk aversion; but warped risk / reward is likely the greater driver for the recently volatile FX market. This past week, the DailyFX Carry Trade Index fell 126 points to 27,811 – notable in the decelerated pace of the drop compared to previous week but also that it is a new multi-month low. Reflecting the extent of the move through the past few weeks, fear measured in the Volatility Index has also picked up back above the key 10 percent figure. The outlook for direction is clearly catching up to the activity in spot with USDJPY risk reversals pull back to 3.11.

From testing six-month highs only a few weeks ago, the carry trade has sense tumbled to multi-month lows. However, this sharp drop in the coveted yield strategy doesn’t seem to be just another round of risk aversion. In fact, optimism has actually been spurred on by a recovery in equity markets across the West as well as the relief felt in the sharp reversal of commodity prices. On the other hand, news and data still reflects a lack of liquidity in the credit market and ongoing problems for the financial sector.
For banks, a deceleration in global growth and ongoing write downs on mortgage derivatives are now being joined by forced repurchases of auction rate debt. The derivatives were sold to clients before liquidity seized and a market virtually disappeared, leading regulators to swoop in. Altogether, the rising problems in the financial sector and the jump in volatility across the asset spectrum (even if that volatility is derived from a drop in commodity prices) are unfavorable conditions for any strategy that makes a steady income from stable markets. A different concern is the outlook for interest rate differentials (the return component of carry’s risk/reward). While expectations for the BoJ are for no change, the Fed is expected to begin a series of rate hikes while central bank’s for high-yielding countries are forecasted to institute deep cuts.

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.

Published on  Mon, Aug 18 2008, 06:35 GMT

77c69bd7-80e3-41fb-8f08-9b4c8cf4263e

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US Dollar Rally Masks A Severe Carry Breakdown

Mon, Aug 11 2008, 12:18 GMT
by John Kicklighter

DailyFX

While all eyes were on the US dollar’s major breakout effort towards the end of this past week, a look away from the majors revealed another major currency market trend change: the breakdown in the carry trade. By Friday’s close, the DailyFX Carry Trade Index closed at 27,954 after a 571 plunge from last week which brought the basket to its lowest level since April 14th.

• US Dollar Rally Masks A Severe Carry Breakdown

• Concerns Over Liquidity And Lending Continue To Play Credit Market

• Can The USDJPY Lead A Carry Rebound, Or Is Doomed To The Same Fate As Carry?

While all eyes were on the US dollar’s major breakout effort towards the end of this past week, a look away from the majors revealed another major currency market trend change: the breakdown in the carry trade. By Friday’s close, the DailyFX Carry Trade Index closed at 27,954 after a 571 plunge from last week which brought the basket to its lowest level since April 14th. This sharp reversal officially curbed any speculation that demand for interest rate differentials could push to new highs while risk appetite faded and the potential for returns faded. Not surprisingly, the supplementary data we monitor has deteriorated along with the drop in carry. Action in the currency market drove the DailyFX Volatility Index back above the closely watched 10 percent level. At the same time risk reversals have still favored calls and seemingly beneficial USDJPY bullishness. However, this is a fundamental anomaly.

Aside from the USDJPY’s advance this past week, almost every other carry sensitive pair plummeted (thereby driving the Carry Index down). This setback for the popular income strategy is not surprising considering the evolution of fundamentals and market conditions over the past few weeks (and months). Impacting trends just this past few days, Moody’s warned that it was forecasting 10 percent of borrowers in speculative grade bonds would default over the coming year – putting not only liquidity in jeopardy, but severely reducing the risk of returns for carry and basic lending. Elsewhere, Fannie Mae reported it would be increasing fees, reduce its high risk mortgage buying and charge higher risk premiums – reducing the available pool of capital and reducing the safety net the popular GSE offered to the market. Another concerning announcement was the joint report from a number of major banks (JP Morgan, Merrill Lynch, Citi, HSBC, Lehman, among others). They suggested a willingness to invest in technology and risk management, bring their structured products into view of regulators and allow only the most wealthy and savvy individuals invest in the hard hit derivatives – a prominent sign that they are afraid conditions could become much worse.

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.

Published on  Mon, Aug 11 2008, 12:18 GMT

c5ed02cb-3ecb-4f87-adc6-ef298aaaf698

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A Sharp Reversal Threatens The Rebound In The Carry Trade And Risk Appetite

Fri, Jul 25 2008, 12:15 GMT
by John Kicklighter, Antonio Sousa

DailyFX

A sharp drop in high-yielding currencies and equities over the past few days may have sabotaged a crucial rebound in risk appetite and the currency market’s favored carry trade. Since last Friday, the DailyFX Carry Trade Index has dropped 336 points after briefly pushing to a new four-month high. Now, the index is threatening to officially close the rebound from March’s swing low as spot hovers just above notable support in a prevailing wedge formation.

• A Sharp Reversal Threatens The Rebound In The Carry Trade And Risk Appetite

• Volatility And Risk Reversals Suggest Carry Selloff May Be Short Lived

• Are Falling Rates Among The High Yielders The Next Weight Barrier To A Realized Carry Rebound?

A sharp drop in high-yielding currencies and equities over the past few days may have sabotaged a crucial rebound in risk appetite and the currency market’s favored carry trade. Since last Friday, the DailyFX Carry Trade Index has dropped 336 points after briefly pushing to a new four-month high. Now, the index is threatening to officially close the rebound from March’s swing low as spot hovers just above notable support in a prevailing wedge formation. However, market condition indicators certainly do not support fears of an imminent breakdown in the carry and general risk sentiment. Volatility across the currency market has actually dropped 0.61 percentage points to 9.75 percent – the lowest level since late February – suggesting speculation of a potential breakout is low. What’s more, the steep drop in USDJPY risk reversals (denoting growing demand for puts) from last week has made an about face of its own..

From a fundamental standpoint, the health of risk appetite - and consequentially the carry trade - is just as mixed as the technical formation in the carry basket would suggest. On the upside, the credit and financial market fears centered on the potential collapse of Freddie Mac and Fannie Mae have eased as both lenders’ conditions seem to have stabilized. Along similar lines, market participants’ and economists’ worst case scenarios for second quarter earnings were never met. However, earnings are still down, banks have reported another round of staggering write offs and mortgage markets continue to teeter. Further adding to the pressure on risk appetite, the capital markets are still pitched into bearish territory and policy authorities are officially taking steps to depress yield differentials. Just a short-time ago, the RBNZ surprised the market with its first rate hike in years. This negative rate bias for the high-yielding currencies stands in direct contrast to forecasts for tightening for funding currencies. Going forward, the market will be closely weighing the potential for returns against the threat of volatility when gauging the future of the carry trade.

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 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.

Carry Basket Component Currencies:

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.

Published on  Fri, Jul 25 2008, 12:15 GMT

c0b87966-708c-4f86-90d1-15e7626cdad3

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A Carry Breakout A Matter Of Time As Earnings And Credit Crowds Headlines

Fri, Jul 18 2008, 11:08 GMT
by John Kicklighter, Antonio Sousa

DailyFX

Despite a sharp increase in credit market concerns surrounding the health of Freddie Mac and Fannie Mae, as well as caution heading into the thick of the second quarter earnings season, carry interest actually rose over the past week. The DailyFX Carry Trade Index rose 124 points from last week to 29,059. However, further upside progress has clearly be curbed by a triple top that has dampened risk appetite since May.

• A Carry Breakout A Matter Of Time As Earnings And Credit Crowds Headlines

• Volatility And Put Interest Has Jumped To Multi-Month Highs

• If Freddie And Fannie Are Secured And Earnings Strong, Can Carry See An Upside Break?

Despite a sharp increase in credit market concerns surrounding the health of Freddie Mac and Fannie Mae, as well as caution heading into the thick of the second quarter earnings season, carry interest actually rose over the past week. The DailyFX Carry Trade Index rose 124 points from last week to 29,059. However, further upside progress has clearly be curbed by a triple top that has dampened risk appetite since May. Whether or not demand for return and the carry trade index itself can finally push through resistance will likely depend on the resolution to the US policy officials handling of their insolvent GSEs and the size of the largest investment banks’ write downs. In the meantime, fear is certainly tangible in the market condition indicators. The DailyFX Volatility Index (a good gauge of fear) saw its sharpest jump since March with a 0.77 percentage point increase to 10.79 percent. This concern over a possible breakout happened to accompany a sharp increase in put buying, suggesting traders already have one foot out the exit just in case.

The DailyFX Carry Trade Index’s recent price action characterizes the market’s approach to risk relatively well. This past week, the debate over the health and solvency of Freddie Mac and Fannie Mae roiled the capital markets. However, assurances by policy officials that the firms are well capitalized has seemed to calm the storm somewhat. Nevertheless, suggestions that the government may buy unlimited shares of both, open the discount window for them or may take a more uncouth approach to bailing the country’s biggest lenders comes with problems of its own. The US government is flirting with nearly doubling its debt load in offering help and inadvertently encouraging overconfidence that their will always be a back up for banks taking unnecessary risk. The other major uncertainty surrounding the financial markets is the severity of second quarter earnings disappointments and write downs. So far, the damage has been limited with JP Morgan and Blackrock outperforming expectations. However, Merrill Lynch’s $9.7 billion write down and worst than expected net loss are certainly keeping investors on their toes.

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 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.

Published on  Fri, Jul 18 2008, 11:08 GMT

9b37d1a2-b364-4b57-b140-5dcdc6f69583

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Carry Nears A Breakout As Earnings Gear Up And Credit Fears Rise

Mon, Jul 14 2008, 09:45 GMT
by John Kicklighter, Antonio Sousa

DailyFX

While the DailyFX Carry Trade Index was modestly higher over the past week, the strategy (and overall risk sentiment) is on the verge of a breakout with earnings season kicking off and signs of a deepening financial crisis popping up all over the market. Today, the carry index stood at 28,935 – 101 points above last Friday’s level. However, looking at the chart below, it is easy to grasp the pressure building behind an inevitable break in the market’s cautious stance. Since May, the basket has cut an ascending wedge with a horizontal resistance around 29,050.

• Carry Nears A Breakout As Earnings Gear Up And Credit Fears Rise

• Pressure Building In Market Condition Indicators And Exchange Rates

• Freddie Mac And Fannie Mae: Evidence The ‘Financial Crisis’ Isn’t Over?

While the DailyFX Carry Trade Index was modestly higher over the past week, the strategy (and overall risk sentiment) is on the verge of a breakout with earnings season kicking off and signs of a deepening financial crisis popping up all over the market. Today, the carry index stood at 28,935 – 101 points above last Friday’s level. However, looking at the chart below, it is easy to grasp the pressure building behind an inevitable break in the market’s cautious stance. Since May, the basket has cut an ascending wedge with a horizontal resistance around 29,050. Perhaps offering a bias for the eventual trend development, market condition indicators are actually working their way lower despite improvements seen this past week. USDJPY risk reversals corrected considerably from its highest levels since last October and the volatility index is holding above the critical 10 percent figure.

The rebound in risk appetite seen from the March swing low has been slowly curbed by various signs that credit conditions and a lack of liquidity are still burdening the financial markets. Recently, a Bank of England credit report forecasted that the credit market – the life blood of investment – would worsen through the third quarter. Such a forecast is troubling considering European banks are paying the highest prices in a decade to raise capital just to meet reserve requirements, while the governmentally sponsored Fannie Mae and Freddie Mac in the US are paying record yields in their own efforts to fortify reserves. In the weeks ahead, speculation that these two lenders may require a government bailout or face bankruptcy will help to define the overall direction of risk trends; and the debate is lively. St. Louis Fed President William Poole has suggested the government step in now as the companies are essentially insolvent. Another driver for risk trends and the carry trade will be banks’ second quarter earnings numbers, which start to hit the wires next week.

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.

Published on  Mon, Jul 14 2008, 09:45 GMT

9e09857f-da84-4e07-a774-d12abadf62c4

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Concern Over Global Rates And Growth Stalls The Rebound In Carry

Fri, Jul 4 2008, 05:54 GMT
by John Kicklighter

DailyFX

The DailyFX Carry Trade Index was practically unmoved from last week after heavy event risk failed to generate direction for the yield strategy. In fact, carry interest has actually worked its way into a period of congestion that has sapped all of the momentum out of the developing rebound after the March reversal. This indecision likely comes from the clouded outlook for global interest rates with deteriorating growth trends making its difficult for policy makers to focus on the greatest inflation pressures in a generation. Certainly this uncertainty was reflected not only in price action, but market conditions as well. Volatility in the currency market jumped back firmly back above the 10 percent mark; and USDJPY risk reversals have experienced a sharp jump in the demand for protective puts.

• Will A Restored Correlation Between Carry And Equities Pull The Yield Strategy Down?

• Forecasts For Ongoing Write Downs, Liquidity Concerns And Recessions Still Evident

The DailyFX Carry Trade Index was practically unmoved from last week after heavy event risk failed to generate direction for the yield strategy. In fact, carry interest has actually worked its way into a period of congestion that has sapped all of the momentum out of the developing rebound after the March reversal. This indecision likely comes from the clouded outlook for global interest rates with deteriorating growth trends making its difficult for policy makers to focus on the greatest inflation pressures in a generation. Certainly this uncertainty was reflected not only in price action, but market conditions as well. Volatility in the currency market jumped back firmly back above the 10 percent mark; and USDJPY risk reversals have experienced a sharp jump in the demand for protective puts.

Looking at the fundamental influences behind the carry trades lack of direction, there may be more at work than merely concern over the sustainability of wide yield differentials. Instead, recent data and dour forecasts from policy officials and analysts suggests financial markets may be heading for another crisis that rivals what followed the subprime market collapse last year. First of all, the equity markets have tumbled and the carry trade has yet to catch up. In recent history, the overwhelming influences of risk trends over the market have led the carry trade pairs and equities to move more or less in lock step. However over the past few months, the two have diverged with USDJPY climbing to four-month highs, while the Dow pushes to lows not seen since August of 2006. The correlation may return however, if forecasts for worsening credit conditions are realized. Moody’s has forecasted a five fold increase in defaults over the coming year, while a recent credit report from the BoE clearly states UK lending will worsen in the coming three months. Ultimately, with banks still starving for liquidity and writedowns expected to continue, it seems like the dominos are much bigger this time around.

Carry Basket Component Currencies:

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.

Published on  Fri, Jul 4 2008, 05:54 GMT

7e719488-9cc6-424f-94f9-bccf787bfe68

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A Sharp Drop In Risk Appetite Cuts A Possible Carry Trade Breakout Short

Mon, Jun 30 2008, 08:55 GMT
by John Kicklighter, Antonio Sousa

DailyFX

Interest rate expectations recharged the carry trade this past week; but a significant jump in risk aversion throughout the capital markets curbed the currency strategy. On balance, the shock from the sharp equities sell off yesterday reversed earlier gains in the DailyFX Carry Trade Index leaving the gauge 57 points lower on the week at 28,843. Supporting the air of caution in an otherwise strong carry trend, market condition indicators were reflecting modest improvements from last week. Currency traders were still relatively confident in the outlook yield demand and less concerned over the possibility of panic selling. Risk reversals for USDJPY (the proxy for the carry) rose as calls grew in value; and the DailyFX Volatility Index fell back below 10 percent following last week’s unexpected jump.

• A Sharp Drop In Risk Appetite Cuts A Possible Carry Trade Breakout Short

• Credit Market Conditions Improve While Capital Markets Tumble, Is This A Natural Bear Market?

• Interest Rate Differentials May Not Offset Possible Capital Losses With Risk Rising

Interest rate expectations recharged the carry trade this past week; but a significant jump in risk aversion throughout the capital markets curbed the currency strategy. On balance, the shock from the sharp equities sell off yesterday reversed earlier gains in the DailyFX Carry Trade Index leaving the gauge 57 points lower on the week at 28,843. Supporting the air of caution in an otherwise strong carry trend, market condition indicators were reflecting modest improvements from last week. Currency traders were still relatively confident in the outlook yield demand and less concerned over the possibility of panic selling. Risk reversals for USDJPY (the proxy for the carry) rose as calls grew in value; and the DailyFX Volatility Index fell back below 10 percent following last week’s unexpected jump.

The carry trade is in an interesting position this week. On the one hand, many of the benchmark carry pairs are still near the highs of their respective rallies – and the recent pull back has certainly not threatened the hearty trends. Conversely, the capital markets have undergone a clear reversal in risk sentiment with equity markets tumbling to new lows. In fact, with Thursday’s close, the Dow was at its lowest level since November of last year while European shares plunged to levels not seen since November of 2005. With USDJPY over 1,100 points above its own multi-year low and the Dow just now pressing to fresh lows, it seems that the risk correlation is breaking down. However, this has likely been facilitated by steady improvements in the credit market which leads us to believe the bearish turn in capital market’s is of a ‘natural’ sort and not the panic surrounding investment stability from last summer. Nonetheless, a decline in equity markets generally suggests risk appetite and yield are on the wane – unfavorable conditions for carry. Furthermore, with the Fed and ECB threatening hikes and RBNZ seeing cuts while the RBA holds, the potential for return is fading as risk rises.

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.

Carry Basket Component Currencies:

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.

Published on  Mon, Jun 30 2008, 08:55 GMT

5c8a43f3-112a-4047-b30a-6b9483401b48

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Carry Trade Advance Fails As Yield Forecasts Favor Carry Currencies

Fri, Jun 20 2008, 08:57 GMT
by John Kicklighter, Antonio Sousa

DailyFX

Last week’s pull back in the carry trade has turned into a full-blown reversal as yield differentials contract and risk aversion rise. This past week, the DailyFX Carry index fell 364 points to 28,489 – brining it back below the falling trendline that had been breached in an upside break at the end of May. This reversal comes with significant support from market condition indicators. Volatility – an unwanted factor when looking to collect steady income on the carry – marked a significant rebound as other risky assets accelerated recent losses. The DailyFX Volatility Index in fact jumped 0.37 points to 10.7 percent. At the same time, yield differentials have narrowed with interest rate products pricing in 43 bps of tightening from the BoJ over the coming year.

• Carry Trade Advance Fails As Yield Forecasts Favor Carry Currencies

• USDJPY The Stand Alone Clear Bull Among The Yen Crosses

• Volatility On The Rise As Risk Appetite Falls Across The Financial Market

Last week’s pull back in the carry trade has turned into a full-blown reversal as yield differentials contract and risk aversion rise. This past week, the DailyFX Carry index fell 364 points to 28,489 – brining it back below the falling trendline that had been breached in an upside break at the end of May. This reversal comes with significant support from market condition indicators. Volatility – an unwanted factor when looking to collect steady income on the carry – marked a significant rebound as other risky assets accelerated recent losses. The DailyFX Volatility Index in fact jumped 0.37 points to 10.7 percent. At the same time, yield differentials have narrowed with interest rate products pricing in 43 bps of tightening from the BoJ over the coming year.

A rising wave of risk aversion has swept over most financial market this past week; and the carry trade was just another one of the victims. Selling pressure has overwhelmed the rebound in equities, government debt yields and yen and franc currency crosses as central banks the world over turn to hawkish rhetoric - that distinctly threatens rising interest rates sooner rather than later - even though economic expansion is still struggling. The interest rate component of this flight from risk would usually benefit the yield-dependant carry trade; but the policy outlook has actually worked against wider differentials. The interest-heavy New Zealand dollar has received confirmation from the RBNZ that a cut is on the way. Less action oriented, the Aussie central bank is just now coming into a concerning slowdown in economic activity. On the low end of the curve however, the market is pricing in a near 47 percent chance of a Fed hike in August and 139bps of cumulative tightening over the year. Even the BoJ is now looking at 41bps of firming by next year.

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.

Published on  Fri, Jun 20 2008, 08:57 GMT

53039cd7-eefc-430d-84d9-8ee783e8f24e

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Carry Trade Unwinding Follows A Market−Wide Selling Of Risk

Mon, Jun 9 2008, 07:01 GMT
by John Kicklighter, Antonio Sousa

DailyFX

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.

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.

Published on  Mon, Jun 9 2008, 07:01 GMT

4667066d-42ad-496f-85f1-a8d0268134a3

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Carry Trade Gains As Yields Turn Higher, Global Growth Outlook Improving

Mon, Jun 2 2008, 08:27 GMT
by John Kicklighter, Antonio Sousa

DailyFX

• Carry Trade Gains As Yields Turn Higher, Global Growth Outlook Improving

• Fed Boosts Liquidity Even As Demand Fades

• Market Condition Indicators Improve As Risk Returns For Most Assets

The global credit crunch seems to be loosing its grip on the financial markets; and in its place, improving liquidity levels and growth outlook have revived a taste for risk. For the currency market, the appetite for yield boosted the DailyFX Carry Trade Index $123 to $29,020 and extended a modest yet steady advance for the basket. What’s more, with this past week’s strength, the market seems to have pushed through resistance in a descending trend channel that has guided carry lower since the subprime meltdown last summer. Alongside the improvement in price action, market activity indicators similarly improved. The DailyFX Volatility Index edged closer to the 10 percent-mark as fears of major capital losses ease. At the same time the directional risk reversals have maintained their down trend.

Markets are showing the tell-tale signs that central banks’ efforts to restore liquidity to the frozen credit market are paying off. Over the past few weeks, demand for stocks and commercial and government debt has pulled each asset class out of steep declines that have guided price action since the second half of last year. In turn, volatility has settled; and sidelined capital is finding its way back into high-yielding and risk-sensitive assets. Adding to the positive outlook for investment conditions were the outlook for interest rates and growth in the US. The revision of the first quarter GDP figure boosted speculation that the world’s largest economy would avoid a recession and thereby revive global growth. In turn, futures show the market believes the FOMC may begin raising rates later this year and restore returns. The Fed’s efforts to insure liquidity to the markets seems to further these expectations. The policy group announced three more $75 billion TAF infusions in June even as a $25 billion auction to investment firms on Thursday received only $16.4 in bids.

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 cary 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.

Published on  Mon, Jun 2 2008, 08:27 GMT

c16adab6-7d47-4b3e-a375-a5bf741f05fe

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Rebound In Carry Trade Hits Resistance As Risk Appetite Falters

Mon, May 26 2008, 06:05 GMT
by John Kicklighter, Antonio Sousa

DailyFX

The carry trade has maintained its upward trajectory, but the popular strategy has certainly lost steam. The DailyFX Carry Trade Index rose modestly since last week to 28,928 – though this advance merely lifts the basket to the top of a developing congestion zone and more importantly to the significant downward sloping trendline that has defined sentiment since last summer. Looking at broader risk trends, this divisive trendline may hold up to any further carry rebound. Capital markets have already marked a sharp reversal while fear has boosted volatility and demand for puts. However, the DailyFX Volatility Index shows market activity is still near its lowest levels since February. Furthermore, the outlook in option markets still shows a considerable bias towards USDJPY calls.

• Rebound In Carry Trade Hits Resistance As Risk Appetite Falters

• Sharp Downturn In Equities Threatens To Weigh On All Risky Assets

• Volatility And Other Market Conditions Catching Up To Turn In Price

The carry trade has maintained its upward trajectory, but the popular strategy has certainly lost steam. The DailyFX Carry Trade Index rose modestly since last week to 28,928 – though this advance merely lifts the basket to the top of a developing congestion zone and more importantly to the significant downward sloping trendline that has defined sentiment since last summer. Looking at broader risk trends, this divisive trendline may hold up to any further carry rebound. Capital markets have already marked a sharp reversal while fear has boosted volatility and demand for puts. However, the DailyFX Volatility Index shows market activity is still near its lowest levels since February. Furthermore, the outlook in option markets still shows a considerable bias towards USDJPY calls.

The correlation between the carry trade and other risk-sensitive assets will be put to the test over the coming weeks and months. We have seen recently that the tight connection between the carry trade, equities and other high-yielding instruments - that was so strong through the subprime meltdown and credit crunch - has faded with investors slowly moving out of highly liquid assets and back into those that actually provide return. If the correlation continues to hold, the considerable reversal in equities may foreshadow a similar drop in the yen crosses. On the other hand, this equities’ reversal has yet to turn speculative futures, raise risk premium in default swaps, or alter underlying trading conditions. In fact, volatility in the equities market (as measured by the VIX) has risen little from its recent 10-month low and the put-call ratio continues to hit new lows for the year. This notable divergence suggests equities are merely following economic trends (speculation the Fed is done lowering rates) and risk trends may no longer be a market wide influence.

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.

Published on  Mon, May 26 2008, 06:05 GMT

c023c9f3-2e85-42bc-ba68-ceb3c3d385d3

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Rebound In Carry Interest Measured As Traders Weigh Credit, Fundamental Conditions

Wed, May 21 2008, 07:12 GMT
by John Kicklighter, Antonio Sousa

DailyFX

Though it is a relatively tentative rise, risk trends seem to be broadly improving. The DailyFX Carry Trade Index has maintained the upward trajectory that has held since the March reversal. What’s more, a look to the details underlying this advance reveals most of the general conditions surrounding risk appetite are improving. The DailyFX Volatility Index shows price action is stabilizing into its steady rally with expected fluctuations for the coming three months cooling to 2.88 percent. As for the outlook for USDJPY (the carry trade proxy), interest is shifting to bullish calls even as speculation that a BoJ rate hike is in the pipeline gains traction.

• Rebound In Carry Interest Measured As Traders Weigh Credit, Fundamental Conditions

• Risk Appetite Rising As Global Growth Trends Reflecting Little Of The Financial Turmoil

• Divergence Between Carry And Other Risky Assets Prominent

Though it is a relatively tentative rise, risk trends seem to be broadly improving. The DailyFX Carry Trade Index has maintained the upward trajectory that has held since the March reversal. What’s more, a look to the details underlying this advance reveals most of the general conditions surrounding risk appetite are improving. The DailyFX Volatility Index shows price action is stabilizing into its steady rally with expected fluctuations for the coming three months cooling to 2.88 percent. As for the outlook for USDJPY (the carry trade proxy), interest is shifting to bullish calls even as speculation that a BoJ rate hike is in the pipeline gains traction.

Looking beyond general market conditions, the fundamentals of the past few weeks certainly offer some perspective into the general rebound in risk appetite and why the carry trade has not returned to the forefront of the yield hunt. First, looking outside the currency market, there has been a clear reversal in the demand for yield seen with the steady advance in equities, strength in speculative commodities, a rise in bond yields and sharp reversal in credit spreads. Recently, this has been supported by global GDP numbers that have consistently bested the market’s dour forecasts. This is an unusual outcome for most economists and market participants as the severity of the credit market crisis had reached a fever pitch through the first quarter; and the effects were expected to hit economic expansion hard. Policy makers at the major central banks have been the main source for relief as the demand for liquidity has been largely satiated by aggressive injections. At the same time though, the rebound in carry has somewhat lagged the strength in other markets suggesting investors are far more cautious of risk with the fallout from the credit crunch still fresh in most traders’ minds.

Carry Basket Component Currencies:

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 are 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.

Published on  Wed, May 21 2008, 07:12 GMT

e45d2626-c012-4411-b5cd-d0d9534ec2b8

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Massive Bank Losses And Write Downs Drag Risk Appetite And Carry Lower

Mon, May 12 2008, 06:12 GMT
by John Kicklighter, Antonio Sousa

DailyFX

The high end of the yield curve has taken a significant hit over the past week; and carry trades have suffered the consequences. The DailyFX Carry Trade Index sunk $298 dollars since last Friday after failing to over take a descending trendline that has been directing the basket since risk appetite was tripped up by the subprime meltdown last summer. In turn, a breakdown in USDJPY and other yen crosses has weighed on risk reversals, which show a greater demand for puts. However, during this reversal, the outlook for a BoJ hike over the coming year has eased and volatility cooled, suggesting this will be a more orderly (and perhaps short-lived) carry unwind.

• Massive Bank Losses And Write Downs Drag Risk Appetite And Carry Lower

• Fed Increases Its Bi-Weekly TAF Auctions And Broadens Acceptable Collateral

• High Yield Currencies Plunge Across The Board As Economic Conditions Dim

The high end of the yield curve has taken a significant hit over the past week; and carry trades have suffered the consequences. The DailyFX Carry Trade Index sunk $298 dollars since last Friday after failing to over take a descending trendline that has been directing the basket since risk appetite was tripped up by the subprime meltdown last summer. In turn, a breakdown in USDJPY and other yen crosses has weighed on risk reversals, which show a greater demand for puts. However, during this reversal, the outlook for a BoJ hike over the coming year has eased and volatility cooled, suggesting this will be a more orderly (and perhaps short-lived) carry unwind.

There were few market factors working in carry’s favor this past week. The most prominent element to the strategy’s performance came towards the end of the week when major financial firms Citigroup and AIG announced considerable losses and write downs. Perhaps taking the SEC’s new policy for companies to disclose their liquidity and capital positions to revive confidence in the financial markets, Citi took the unprecedented move of announcing plans to sell $100 billion in non-core businesses and $400 billion in low-yielding assets over the next few years to boost its capital position. This ‘write down’ accounts for more than 20 percent of the entire company. Another major weight on the carry basket came from a series of bad data from the high yielders. The most significant hit came from the New Zealand employment number, which dropped the most in 19-years. Amidst this heavy-handed data however, the Fed was once again the silver lining. The policy authority announced it would expand its TAF auctions from $50 to $75 billion and accept asset-backed debt.

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 (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 are 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.

Published on  Mon, May 12 2008, 06:12 GMT

b23e7a88-7453-4697-ba03-f65a75e08820

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Carry Trade On The Rise As Volatility Cools, Rate Differentials Improve

Mon, May 5 2008, 09:00 GMT
by John Kicklighter, Antonio Sousa

DailyFX

Through there is growing concern as to how long high yielding currencies like the New Zealand and Australian dollars can keep their rates at record highs, interest in the carry trade has still improved over the past week. The DailyFX Carry Trade Index rose $296 since last week with help from a modest cooling in currency market volatility and a general improvement in the outlook for the yen crosses.

• Carry Trade On The Rise As Volatility Cools, Rate Differentials Improve

• Fed And BoE Boost Risk Appetite By Widening Their Collateral Nets

• Caution Still In Place As Market Questions High Yielders Buoyancy

Through there is growing concern as to how long high yielding currencies like the New Zealand and Australian dollars can keep their rates at record highs, interest in the carry trade has still improved over the past week. The DailyFX Carry Trade Index rose $296 since last week with help from a modest cooling in currency market volatility and a general improvement in the outlook for the yen crosses.

There has been a tangible rebound in risk appetite over the past few weeks; and the carry trade has been one of the primary benefactors. Considering the thawing in credit markets recently, it seems that the cooperative effort by global central banks to revive liquidity is paying off. In fact, even with conditions improving, the Bank of England and Federal Reserve have upped their efforts to put financial markets on an even keel once and for all. Both the Monetary Policy Committee the Fed announced it they were widening their definitions of acceptable collateral for access their respective liquidity injections. These efforts must be potent indeed considering volatility has cooled and the carry basket has rallied over the past few weeks despite headlines of further writedowns from big banks and warnings from the BoE that falling UK commercial property values may trigger considerable defaults and another wave of massive losses for banks. And, while conditions seem to be improving for the carry trade, the mood is still one of caution. While pairs like USDJPY, USDJPY and GBPJPY have put in for a tentative trend change, the higher-end of the yield curve is actually starting to fall as traders expect the central banks with high benchmark rates will eventually be forced to ease like the Fed, BoE and BoC.

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