• Home ::
• Technical ::
• Forex Strategy ::
• Dynamic Carry Basket

• Send
• Print
• Add To
• Rss

Dynamic Carry Basket

3fedcd3d-b832-4d75-9f2a-c10642309de3

11

0

Volatility Is Pulling Back But So To Is The Potential For Return

Mon, Feb 2 2009, 06:19 GMT
by John Kicklighter

DailyFX

• Currency Market, Sentiment On The Verge Of Another Plunge As Growth And Rates Deteriorate

• Volatility Is Pulling Back But So To Is The Potential For Return

• Bailout Efforts Are Growing, But There Are Still Potential Stumbling Blocks To Improvement

Investor sentiment is on the verge of another collapse just as efforts to stabilize economic growth and financial markets have been ramped up. Can global policy officials revive investor and lender confidence before the cumulative pessimism behind underlying fundamental trends picks a direction for the us? We won’t likely have to wait long for an answer. Taking measure of sentiment through yield appetite, we have seen carry trade interest struggle to balance the weak potential for returns with the growing outlook for risk. This past week, the DailyFX Carry Trade Index held back from developing formal follow through with a third dip below 20,000. Nonetheless, the pressure is clear as the composite holds just above a six-year low. This weight was more or less mirrored in the market’s other, favored risk-sensitive assets. The S&P 500 was pressuring support around 800, the EURUSD was eyeing 1.2750 and the ten-year T-note was threatening to drop below 122 (an interesting mix that itself reflects an unusual environment). On the other hand, where price gauges have stumbled, market condition indicators have actually improved. The DailyFX Volatility Index has retraced to 19.3 percent and risk reversals have shown an uptick in optimism among options traders - though, both are still near recent record lows.

When looking at the fundamental clash underlying market sentiment, we are left with little reason to doubt the potential for another wave of pessimism. Over the past few weeks, investors have been given more than enough reason to second guess optimism. The primary concern for investors, consumers, businesses and politicians is the health of the global economy. The IMF has forecasted a 0.5 percent pace of expansion through 2009 – a technical recession for an economy of this scale and put into context, the worst pace of activity since World War II. This forecast may even be somewhat optimistic compared to what speculators are preparing for after the fourth quarter GDP numbers were folded into the mix. The world’s largest economy reported a substantial 3.8 percent annualized slump through year’s end, while activity in the UK slowed 1.8 percent over the same period – the worst contraction in over a quarter of a century for both. At this point, though, the absolute level of these lagging indicators isn’t nearly as important as the pace they have established. As the engine of the decline moves from housing to business activity on to consumer spending, the momentum behind the recession is being amplified. How overwhelming will this trend be? This is a critical question now as US President Barack Obama is pushing through an $800 billion-plus stimulus plan and other policy authorities move towards nationalizing their financial sectors. What is clear though is that sparking optimism after tremendous loses and with such anemic returns will be an extremely difficult task.

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, Feb 2 2009, 08:03 GMT