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Dynamic Carry Basket

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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

FXCM

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, 08:47 GMT