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Dynamic Carry Basket

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Risk Trends And Carry Flows Hit Six Year Lows, On The Edge Of Another Plunge

Mon, Jan 26 2009, 06:09 GMT
by John Kicklighter

DailyFX

With USDJPY testing thirteen year lows and the Dow pushing 8,000, it was hard to miss the rising sense of risk aversion last week. Now, as indicators of growth and concerns the financial stability of world’s largest economies comes into focus, market participants may finally be forced to take a stand on their outlook for the balance between risk and reward and thereby define the next major trend.

• Risk Trends And Carry Flows Hit Six Year Lows, On The Edge Of Another Plunge

• What Are The Potential Drivers For The Next Wave Of Deleveraging?

• Are The Markets Fully Accounting For The Global Recession’s Impact On Risk and Yields?

With USDJPY testing thirteen year lows and the Dow pushing 8,000, it was hard to miss the rising sense of risk aversion last week. Now, as indicators of growth and concerns the financial stability of world’s largest economies comes into focus, market participants may finally be forced to take a stand on their outlook for the balance between risk and reward and thereby define the next major trend. Benchmarking the outcome of this fundamental debate, we defer to the cold hard facts. As a measure of risk appetite, the DailyFX Carry Trade Index followed suit with the market’s other sensitive barometers by briefly testing a new six-year low. However, also like these other gauges, carry would not carry through with its potentially trend-defining break.
Nonetheless, we have to take the probabilities into perspective. Carry unwinding has been significant and we are clearly at the very bottom of the strategy’s recent historical range. What’s more, market condition reports have taken a cautious turn for the worse following timid and temporary improvements. Key among them, volatility across the currency market bounced back above 20 percent. What’s more, risk reversals show a bearish turn in speculative sentiment while global interest rates keep their sites set on a zero policy.

It is more than clear at this point that the market stabilization through the turn of the year was not a sign of an improvement in underlying conditions or fundamentals but rather a pause while investors reassessed the market’s risk / reward profile. Not surprisingly, timely events and indicators have put investors back on the path to deleveraging and in the pursuit of a safe haven for their dwindling capital base. With sentiment clearly shifting, investors will have to take measure of three critical dynamics that shape optimism and the overall direction of the markets. The most unstable driver for price action is the health of the global financial markets. Over the past few weeks, the UK government practically seized control of the Royal Bank of Scotland while US officials have taken enough of a stake in the Bank of America and Citi that it could be considered an unofficial nationalization.
Not only is this a sign that massive injections of liquidity and huge bailout efforts have so far failed to promote stability; but it has further led to questions over the health of the governments that are funding the global rescue effort. Greece, Spain and Portugal have already seen their debt ratings downgraded, and now there is speculation that the UK may see the same. The second concern is the pace of the global recession. UK GDP numbers confirmed the G10 has entered the dulldrums; but if the US fourth growth numbers meet expectations of a 5 percent contract, it may spell depression rather than recession. Finally, returns will be the final factor. The RBNZ is expected to trim another 100 bps from its benchmark, while yields on nearly every market-based asset are simply not able to compensate for the steady rise in risk.

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 26 2009, 06:53 GMT