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Dynamic Carry Basket

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Carry Tests A New Six−Year Low As Strains In The Financial Market Reemerge

Mon, Jan 19 2009, 05:55 GMT
by John Kicklighter

DailyFX

Risk aversion was on the rise once again this past week; but this time, the shift in sentiment was tangible. With global policy makers forecasting a ‘significant’ slowdown in global growth through 2009 and another round of major banks asking for government aid, underlying fundamentals may carry the market’s to their next crisis.

• Carry Tests A New Six-Year Low As Strains In The Financial Market Reemerge

• Global Rates Continue Their Trend Towards Record Lows

• Bank of America, Citi And Barclays's Troubles May Foreshadow The Next Crisis

Risk aversion was on the rise once again this past week; but this time, the shift in sentiment was tangible. With global policy makers forecasting a ‘significant’ slowdown in global growth through 2009 and another round of major banks asking for government aid, underlying fundamentals may carry the market’s to their next crisis. Gauging the health of risk appetite this past week, we can see that the pain was felt not only through more sensitive readings like carry interest and volatility levels but through general market activity. The world’s benchmark equity indexes tumbled from multi-month highs to set equally significant lows towards the end of the week. Credit market numbers saw a sharp jump in default swap premiums and a reversal in investment-grade corporate debt rates. Perhaps the most aggressive turn was in commodities – a market that is more closely related to growth trends than its more speculatively guided counterparts. For the currency market, the rise in risk aversion was notable in key carry and funding currencies. The DailyFX Carry Trade Index tumbled another 778 points through the week – and actually tested a new six-year low mid-week. The risk-sensitive volatility reading on the other hand marked unexpectedly pulled back below 19 percent, perhaps owing to improved derivative markets.

When looking for an explanation to the general rise in fear among the world’s market participants, we certainly do not come up short. While it is important to monitor the change in sentiment from one week to the next, it is vital to place these short-term shifts within the broader context of sentiment. Looking at the risk-sensitive carry trade or equities market, bearish trends are still overwhelming on historical charts and multi-year lows are a credit seizure away. Such conditions largely reflect the threat of a severe global recession and anemic rates of expected return. Updating the market’s already dire outlook for growth trend, central bankers who attended the Bank of International Settlements (BIS) meeting agreed the global economy was set to cool significantly through the coming year. Starting next week, subjective forecasts will find support from lagging government reports. The United Kingdom will be the first nation of the G10 to release its fourth quarter growth numbers on Friday. This number will in turn set up expectations for other nation’s GDP figures for the same period – like the US which is expected to see a massive 5.0 percent annualized contraction that would mark the worst recession since 1982. Aside from growth considerations, the credit market will also be under pressure. Bank of American recently required a life line, while Citi was forced to split and Barclays is nearing collapse. With so many financial institutions showing problems showing problems, we merely need a catalyst for the next crisis.

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, Jan 19 2009, 06:25 GMT