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Dynamic Carry Basket

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Rate Decisions And Bailout Details May Help Determine Risk Appetite And Carry Trade Trends

Mon, Dec 1 2008, 06:18 GMT
by John Kicklighter

DailyFX

The long holiday weekend for the US markets has clearly curbed activity in the dollar and to some degree the entire currency market. However, for all intents and purposes, caution is still the primary sentiment for risk trends and the carry trade.

• Rate Decisions And Bailout Details May Help Determine Risk Appetite And Carry Trade Trends

• Fed Aims Its Stimulus At Housing And Consumers, EU Drafts A Package Of Its Own

• When Will Interest Rates Be A Carry Trade Driver Again?

The long holiday weekend for the US markets has clearly curbed activity in the dollar and to some degree the entire currency market. However, for all intents and purposes, caution is still the primary sentiment for risk trends and the carry trade. Now, looking ahead to next week, the market will have to weigh the effectiveness of ever-growing stimulus packages against the overwhelming influence of a global recession and universal interest rate cuts. Taking stock of where sentiment will go, we first need to gauge the health of the carry trade. We can see from the DailyFX Carry Trade Basket, that carry interest has improved modestly from last week; but a quick look to the past shows, that the basket is still near the very bottom of the strategy’s six-year range. Furthermore, the fact that there is little effort being made to capitalize on the sidelined momentum from last month’s relief rally suggests there is little interest in trying to collect yield when market volatility is keeping the cost of carry very high. In fact, the DailyFX Volatility Index (a composite of implied volatility from three-month options on six of the majors) is still above 20 percent – more than three times greater than the average level of forecasted activity a year ago. More promising is the rebound in risk reversals, which suggests speculative interest is easing its bearish pressure.

Direction and volatility have settled somewhat over the past week due more to liquidity conditions throughout the markets than any real shift in risk appetite. When the market fills out next week the same, major fundamental themes will be at play once again. The stability of the financial markets and health of global growth will be of primary importance. Focus will turn to the US equity markets which have enjoyed their strongest drive since 2001after rebounding from a six-year low. Should this reversal prove to be a genuine trend change, it will be a major step towards reviving risk appetite. More than likely though, the relief in selling pressure was probably just that – a temporary break. A tolerance for risk and demand for yield would have to find a solid foundation in growth to flourish. However, the outlook for the global economy is pointing to recession even through the most conservative estimates. Next week, a few major industrialized nations will offer first and second readings on economic activity.
Expectations are relatively optimistic, so the potential for surprise is substantial. Another direct influence on the carry trade (and the counterpoint to risk appetite) could be changes to key interest rates. The European Central Bank, Bank of England, Reserve Bank of Australian and Reserve Bank of New Zealand are all expected to cut rates next week. Finally, the markets will continue to weigh their confidence in ever-expanding, national bailouts.

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, Dec 1 2008, 06:40 GMT