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Dynamic Carry Basket

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Risk Appetite Seems to Be on The Rebound, But Will It Last?

Mon, Mar 23 2009, 05:53 GMT
by John Kicklighter

DailyFX

There have been prominent recoveries for risk-laden securities across all most of the markets over the past week. Rallies in equities, bonds, commodities and key currencies have afforded us the first clear signal that the worst for investor sentiment may have already passed.

• Risk Appetite Seems to Be on The Rebound, But Will It Last?

• Without a Global Rescue Effort, Financial and Economic Instability Will Spread

• Are the Yen, Dollar And Franc Still Considered Safe Haven Currencies?

There have been prominent recoveries for risk-laden securities across all most of the markets over the past week. Rallies in equities, bonds, commodities and key currencies have afforded us the first clear signal that the worst for investor sentiment may have already passed. However, the bigger themes in fundamentals and trends in price action may keep skeptical and weary traders out of the market until indisputable confirmation can be justify a return to risk appetite. Looking at the markets this past week, anxious bulls have enough to go on. The Dow is 12.5 percent off its multi-year lows, crude is back above $50 per barrel and the high-yielding Australian dollar has rallied against most of its major counterparts. A recovery in so many markets is hard to ignore; but just as all asset classes succumbed to panic and fear back in October, it is just as likely that the these securities recuperate together. Of course, it can be a genuine, long-term recovery or a short-term relief in a much more pervasive decline. ‘Bear market rallies’ are common sites even in the midst of history’s worst market collapses. It is important to keep the sight of the bigger picture. Equities, commodities and the carry trade index are all still engaged in their worst trends in many decades. All it would take at this stage is a minor catalyst to foil the tentative recovery; and there are plenty of these fundamental dangers looming.

The deflation in investor confidence over the past year and a half been extensive and profound. In fact, it has come to the point on more than one occasion that appetite for yield (a permanent element of investing) was completely abandoned for any bastion of security and liquidity. Inevitably, this need for safety of funds will pass; and the balance of risk / reward will once again level out – encouraging traders to take a measured level of risk for the hope of making returns above and beyond what mere government interest rates can provide. However, fundamentals could defer this fated happy ending for quite some time. First and foremost, the global economy is still embroiled in its worst recession since WWII. More importantly, we have yet to see evidence that the slump in economic activity is easing – so a bottom may very well be a long-way off. When economic conditions do bottom out, there is still the issue of yield. Global interest rates (the foundation for all rates of return) are quickly approaching zero. The reinvestment of capital into speculative assets will be slow and cautious as leverage will initially be difficult to come by and the bulk of the crowd will wait until market leaders can produce a definitive recovery. Over the next two weeks, focus will fall on the effectiveness of the Western government’s efforts to stabilize their own economies. So all attempts to turn growth around have failed; and there is a growing consensus that only a global rescue plan can cure the world’s ails. The best hope for coordinating such a politically-charged endeavor will be the G-20 meeting on April 2nd.

Is Carry Trade a Buy or a Sell? Join the DailyFX Analysts in discussing the viability of the Carry Trade strategy in the Daily FX 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.

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 AUDUSD as global interest rates have quickly fallen towards zero and the lines between safe haven and yield provided has become blurred. Australia has a historically high and responsive benchmark, making it more sensitive to current market conditions. When Risk Reversals grow more extreme to the downside, it typically reflects a demand for safety of funds - an unfavorable condition for carry.

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 market prices influence 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 Reserve Bank of Australia (RBA) will make over the coming 12 months. We have chosen the RBA as the Australian dollar is one of few currencies, still considered a high yielders.

To read this chart, any positive number represents an expected firming in the Australian 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 increase and carry trades return improves.

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, Mar 23 2009, 06:03 GMT