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Dynamic Carry Basket

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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, 11:50 GMT