• Home ::
• Technical ::
• Forex Strategy ::
• Dynamic Carry Basket

• Send
• Print
• Add To
• Rss

Dynamic Carry Basket

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, 06:29 GMT