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Dynamic Carry Basket

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A Tentative Rebound In Risk Appetite Starting To Unsettle Congestion, Boost The Dollar And Yen

Mon, Nov 17 2008, 05:51 GMT
by John Kicklighter

DailyFX

Though congestion took over for the currency market through the first half of this month, volatility continued to rise. Now, with risk aversion once again on the rise, the pent up pressure behind the market threatens significant breakouts and the revival of the most aggressive selloff in decades.

• A Tentative Rebound In Risk Appetite Starting To Unsettle Congestion, Boost The Dollar And Yen

• Treasury Cuts Plans To Buy Troubled Asset Back Securities In Favor Of Taking Equity Stakes

• Volatility Continues To Rise As Bigger Leverage And Economic Issues Direct Market

Though congestion took over for the currency market through the first half of this month, volatility continued to rise. Now, with risk aversion once again on the rise, the pent up pressure behind the market threatens significant breakouts and the revival of the most aggressive selloff in decades. Using the carry trade as a barometer for the risk appetite, we can see the markets have already taken the first steps towards restoring the momentum to the now-dominate trend. After peaking last week, the index has marked a sharp reversal, tumbling 775 points to 21,310. To really engage the market though, October’s 19,739 low will need to give way to catalyze panic that has sent investors rushing for the exits in the past (which in turn squeezed liquidity and thereby accelerated the decline). All the significant market conditions are aligned for another crash-like plunge. Aside from the primary drivers of a global recession and need to work off over-leveraged positions, underlying volatility is still four-times its average reading between 2002-2007 – and rising. What’s more, options reveals cautious investors have driven risk reversals to new record (going back 5 years) lows.

As expected, the rebound that we have seen in carry interest and risk appetite through the opening weeks of this month were short-lived. Such aggressive moves, like the one that has developed since August in either direction rarely come without a relief retracement that reestablishes the opposite side of the market. Now, after short-sellers have taken profit and the world’s policy makers have issued their aggressive bailout plans, investors will once again have to turn to the fundamentals behind the market’s futures. Through the medium-term, the global economy is heading for its worst recession in decades. So far, we have merely seen confirmation that the European community has entered a technical recession; but considering the deterioration of data over the past few months (especially in regards to consumer spending), the outlook for the economic activity looks vastly worse. The more pressing issue through the immediate future, however, will be the health of the financial markets. Large bailout packages, near-unlimited access to short-term liquidity and coordinated rate cutes seemed to have brought back some confidence in the basic functioning of markets. On the other hand, recessions bring bear markets and the market is still floating on leverage and credit. All of this must be worked through.

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.

Published on  Mon, Nov 17 2008, 05:56 GMT