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Dynamic Carry Basket

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Risk Appetite, Carry Interest Unstable As Bailout Efforts Are Overwhelmed By Fear And Recession

Mon, Nov 24 2008, 06:37 GMT
by John Kicklighter

DailyFX

Current market conditions are somewhat deceiving. Volatility has edged back and the currency market’s most liquid pairs are entrenched in long-term congestion. However, the atmosphere is ripe for an impending breakout that will soon revive a singular trend for risk aversion and the carry trade.

• Risk Appetite, Carry Interest Unstable As Bailout Efforts Are Overwhelmed By Fear And Recession

• Congestion Across Currency Market Backed By Rising Volatility Points To Imminent Breakouts

• Are Traders And Investors Still Too Optimistic On Growth And Financial Market Conditions?

Current market conditions are somewhat deceiving. Volatility has edged back and the currency market’s most liquid pairs are entrenched in long-term congestion. However, the atmosphere is ripe for an impending breakout that will soon revive a singular trend for risk aversion and the carry trade. The back and forth in general sentiment has been clearly reflected through the consolidation seen in the DailyFX Carry Trade index over the past month – a period of reflection after the crisis-state the markets were in through most of October. However, despite this hesitation, the index has steadily found its way back on track with the dominant trend, nearly retracing the entire rebound at the turn of the month. This suggests the recovery was merely a temporary relief rally that reduced the pressure on the market from potentially over-extended levels. Furthermore, signs like the excessively high levels of volatility in the currency market and the steady build up in interest for bearish yen cross options stand as warnings to the market that there is still significant pressure behind risk trends; and such conditions are not typically associated to reversals but rather continuation.

Over the past four weeks, the markets have turned to consolidation as panic unwinding of risky positions and the frantic flight to safety has tapered off. However, fundamental conditions have certainly not improved since the October drive. In fact, there is debate in the market whether the situation has actually grown worse. As of yet there is no consensus; and this has allowed general sentiment to take on a greater role over market activity than true fundamentals. With momentum finally stumbling, those traders that were short risk saw the opportunity to book profit and capital that was divested during the panic could find its way back into a more orderly market. Nonetheless, even after the strong trend had been reined in, volatility sustained exceptionally high levels and the bearish bias of the past four months was gradually revived. With sentiment extremes curbed, the focus can turn back to the speculation over growth and the health of the financial market to gauge risk and the next phase of the carry trade trend. News and events this past week suggest there are still difficult times ahead. The EU announced the need for a regional bailout package, the SNB was forced to cut their primary lending rate 100bps, and credit risks hit fresh records as the benchmark US equities markets pushed six year lows. More concerning though is the potential failure of US auto manufacturers - a sign that trouble is now on Main Street and not everyone will be saved.

Do you think risk sentiment and carry will rebound? Join the DailyFX analysts in discussing the health of risk appetite 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 24 2008, 06:47 GMT