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Dynamic Carry Basket

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Risk Appetite And Carry On The Verge Of Another Collapse

Mon, Dec 8 2008, 07:03 GMT
by John Kicklighter

DailyFX

Congestion, which has dominated price action for more than a month now, may soon give way to a renewed wave of risk aversion. As data extends the lows of the global recession, interest rates pull yields closer to zero and credit conditions seize on rising default risk, the market will draw closer to the next wave of capitulation and deleveraging.

• Risk Appetite And Carry On The Verge Of Another Collapse

• The Global Economy’s Plunge Into Recession May Revive Panic

• How Will International Yields’ Drive Towards Zero Impact The Eventual Rebound?

Congestion, which has dominated price action for more than a month now, may soon give way to a renewed wave of risk aversion. As data extends the lows of the global recession, interest rates pull yields closer to zero and credit conditions seize on rising default risk, the market will draw closer to the next wave of capitulation and deleveraging. These fundamental influences are clearly read through the activity of the carry trade. Both the dollar and Japanese yen crosses have edged closer to their respective breaking points, while the DailyFX Carry Trade Index is closing in on the seven-year low set in late October at the tail-end of the panic selling that proliferated during that month. This bearish shift in sentiment has not been surprising, rather carry and risky positions have gradually moved lower after a volatile relief reversal. Such a consistent and steady decline is far more suggestive of the strength of the dominant bear trend. What’s more, market condition indicators never truly recovered from readings that suggested risk aversion was the overriding theme for the markets - further suggesting the rebound in prices was merely a brief rally after a temporary trend exhaustion. Volatility in the currency market is still above 20 percent (versus 7 percent a year ago) and risk reversals held near recent historical lows.

Fundamentally, risk appetite has not changed much over the past few months from the fear that first began to drive the markets lower. And, if anything, conditions have actually gotten worse. In October, the plunge in carry (and risk in general) was the culmination of growing default risk, a full seizure in international lending conditions and a round of indicators that confirmed the economic slump that began in the US was global as well as severe. In other words, this ‘perfect storm’ of sorts merely accelerated what was already underlying the market and forced a rush for the exit. Stimulus packages, guaranteed liquidity on short-term funds and bailouts aimed at the financial sector have helped to curb the panic; but left are the true drivers for a natural bear market. Data and events this past week have merely confirmed that the scales of risk and reward are still heavily skewed towards trouble ahead. From the worlds’ largest economy, the National Board of Economic Research (NBER) confirmed the United States has been in a recession since December of 2007, while non-farm payrolls reported more than a half million lost jobs through November to suggest the slump may be the worst the worst since World War II. The sentiment from other industrialized economies is similar. Ultimately, such concerns could be offset if the reward from investing compensated for risk; but another broad range of rate cuts (ECB, BoE, RBA and RBNZ) has left anemic yields.

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:

DailyFX Volatility Index

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, Dec 8 2008, 11:41 GMT