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Dynamic Carry Basket

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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

FXCM

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, 09:17 GMT