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Dynamic Carry Basket

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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, 13:38 GMT