A Perspective on Carry Trading
Monday, April 20, 2009 at 11:10AM ARE carry trades back in Vogue? With all the talk about second derivatives, equity rallies, and for my own part spring sensation in the market place this question is, I think, a natural one to ask. And by all means, I am not the only one who is asking it. Actually, I think most serious FX punters out there are considering (or have considered) whether it is time once again to seriously consider moving into carry trades.
Now; it is probably a pretty good bet that if Alpha.Sources start talking about the return of any kind of market trend you are probably bound to have missed the boat on it from an investment point of view. Not that I am lacking the discourse or anything, but it is hard to escape the feeling that if we have, since mid February and up to this point, sustained the longest equity rally and subsequent low point in volatility since the crisis broke out, we seem very close to a turning point. Danish fund manager Steen Jakobsen ended last week on an ominous note talking about the biggest selling point this year, which naturally suggests that whatever juice present in carry trades have been squeezed out by now. Add to this that the two most popular pieces currently on Seeking Alpha both extol the end of the current rally, and it definitely seems that the end is nigh for the bulls. Finally, there is the more technical and wonkish perspective in which John Kicklighter, Currency Strategist at DailyFx points out that risk appetite might be close to its peak.
There have been someone however pointing to the possibility of taking advantage of the benign market conditions to dip its toe in the market for carry trades. Darrel Whitten points to the JPY as the classic funding currency and suggests to invest in high yielders such as the Real, the Lira and the Rand. Also Andy Abraham voices the potential for carry trades as volatility has gone down.
At this point it would probably be a good idea to point out that there are carry trades and then are ... carry trades. Ok, an explanation is needed I think. As most of you probably know, the carry exploits the non-existence of the uncovered interest rate parity which states that an interest differential between two currencies should be offset by the higher yielder depreciating vs. the low yielder. In fact, the carry trade in so far as it is pervasive will persistently disprove the UIP and exacerbate the deviation from the theoretical equilibrium. This is something which some authors have coined as self-reinforcing arbitrage Brière and Drut (2009), Plantin and Shin (2008), and Orléan (1999). This also means that while you can always build your very own carry trade basket or engage in carry trade through money market instruments, there is bound to be a substantial agree of piggy-backing in the spot market. Basically, you only need to realize that low yielders can be modelled as a positive function of volatility Cairns et al. (2007) and negative function of equity returns or as I have shown, that equities can be modelled as negative beta assets to low yielders (see also, Kohler (2007)).
Essentially, it amounts to the same money being made on the same strategy, but the underlying investment narrative is very different. In the case of a pure carry trade, it is a strategic position whereas in the case of spot market piggy-backing, the investment narrative is bound to be more opportunistic and self-perpetuating in both directions. This also underpins the inevitable sharp reversals in this game which is something Brière and Drut (2009) touch on when they show how carry trades tend to perform poorly in the context of crises whereas fundamental strategies (based on PPP) will outperform carry trades. I tend to agree, but I would simply add that for the intra-day trader the correlations and functional relationship are stronger in an environment with sharp volatility reversals (such as the current one). Of course and following once again Brière and Drut (2009), they also cite sources to suggest that in times of rigorous pursuit of carry trades and thus deviation of the UIP, the FX market tends to exhibit disequilibria along the lines of other "fundamentals". This suggests that reversals will be all the more substantial when they arise, but they will also be just that, reversals, and thus not deviations from what we might coin as carry trade fundamentals.
What About the Current Rally Then?
More specifically, what are those carry trade fundamentals? Despite the fact that whatever points we can derive from the current rally do not represent a solid scientific foundation, the ideas expressed above easily give rise to the following expression for the return of a low yielding funding currency.
Rfx = F(vol, (-) Re)
Where Rfx is the return on a low yielding carry trade funder (e.g. USD/JPY quoted directly), vol is a measure of volatility (e.g. the Vix) and Re is the expected return on equities. It is important to note that this functional form only has merit in the context of crises and thus when volatility is relative high on a mean basis. This is to say that when the market experiences volatility above a given period average, the carry trade fundamentals strengthen. In terms of which equity index, it is worthwhile to think about the point I also mention in my paper derived from Zimmerman et al. (2003) that when volatility is high markets tend to be correlated to a higher degree than otherwise which in turn tends to diminish the benefits from diversification in exactly the period where investors need it the most. Moreover, Zimmerman et al. also show that down volatility is larger than up volatility which would further solidfy the relationship noted above.
With this in mind let us get some charts on the table and bearing in mind that we can't really draw any conclusions from we still get a strong indicative result.
Even the untrained eye should be able to spot the proposed connection here (click for better viewing). If we look at the evolution in the market since end February (chosen because this is roughly where the Vix peaked), volatility has declined, the traditional carry crosses (mainly JPY here) have moved to favor the low yielder, and equities have bounced.
Of course, the devil is also very much in the detail here. Especially, the USD is interesting here since it shows us that this is never going to be a one way street. Currencies are thus relative prices and while the USD/JPY still seem, despite the almost equally low yields, to exhibit carry trade fundamentals the USD is also itself beginning to act like a funding currency not least against the Euro as well as against the Rand (and I would presume other EM higher yielders too). Clearly, there could be another explanation here, namely that of safe haven flows in times of a spike in volatility. Yet, I still think we need to consider the effect from the US' credible commitment to inflate its way out of this issue and how Bernanke might be paving the way for, as some has mused, the mother of all carry trades. A colleague of mine pointed the following out recently during a discussion;
So the big issue is really whether all this excess liquidity will work its way out of the US - and into India, Brazil etc etc - as we move forward, especially since, if getting a recovery turns out to be as hard as everyone seems to think it is then the Fed (et al) are likely to be holding interest rates near to zero for quite some time, and all the saving people will be trying to do (with few genuine investment outlets) will mean that the last "savings glut" may turn out to look like very small beer, and "abundant liquidity" will be the name of the game.
(...)
Could we steadily see the introduction of a "cheap dollar policy", you know, to keep all those exports flowing out, and keep the cost of servicing the US debt down for a while.
Now, apart from the rather ominous prospect of the US running a current account surplus which would mean a quite severe drainage of aggregate global demand, we need to ponder the effects of a regime of convergence towards QE among the developed economies and what this will mean for the carry trade. Stefan Karlsson had a reasonable go at explaining the link between weaker equities and low yielders a while back, but now the question begs as to what will happen once many of the major G7 economists go for QE. Perhaps it will be like Darrel Whitten noted that the flow of funds will simply move towards the EM to an even higher degree. But I would hold this to be true already in the sense that there will always be those who pursue the juicer trades out there which are bound to be demonstrably more risky than others. It will be interesting in this sense to see whether old relationships will hold regardless of the G7's central banks inclination to go for very low interest rates.
The graphs above cover too short a period to merit any conclusion, but investors should be aware of the proposed relationship, when it reverses and then ultimately to quantify it. In essence the key here is to pin down the extent to which currency movements persistently move contrary to fundamental theories.
Don't get Steamrolled
One of the best conceptualizations of the carry trade is still the Economist's Buttonwood and his narration the instant gratification of carry trades and subsequently how investors were picking up dimes in front of an approaching steamroller. In terms of the immediate prospect of benefiting from carry trade, it is thus important to note that while a crisis such as the one we are experiencing at the moment certainly will tend to intensify many of the links through which carry trades manifest themselves, the reversals will also be more abrupt and unpredictable. Also we should never forget Macro Man and his pink flamingos. I am sure that despite my best efforts to pin down a theoretical and empirical relationship here, pink flamingos will be ever present.
On a more wonkish note, I am doing a thorough re-write of my paper on carry trade (see link below) which is based, in part, on the discussion above. I realize that although the empirical results of the original paper are fairly sound, the theoretical framework is quite poor. I, of course, won't stand for that so will try to tidy this part up significantly as well as I am expanding the empirical investigation especially since the regressions in the full sample suffer from some, erm, statistical issues [1]. Stay Tuned.
List of References (+ some extra inspiration)
As you can see from reading Brière and Drut (2009), I have ripped parts of their list of references.
Bank of International Settlements (2006) - The recent behaviour of financial market volatility, BIS Paper No. 29
Brière and Drut (2009) - The Revenge of Purchasing Power Parity on Carry Trades During Crises, CEB Working Paper No. 09/013 Feb. 2009
Cairns J., Ho C. and McCauley R. (2007) - "Exchange Rates and Global Volatility: Implications for Asia-Pacific Currencies", BIS Quarterly Review, March.
Corcoran, Aidan (2009) - The Determinants of Carry Trade Risk Premia, IIS discussion paper no. 287
Kohler D. (2007) - Carry Trades: Betting Against Safe Haven, University of St.Gallen Discussion Paper no. 2007-12.
Olmo, Jose and Pilbeam, Keith (2008) - The Profitability of Carry Trades, Annals of Finance 5: 231-241
Orléan A. (1999) - Le pouvoir de la finance, Odile Jacob Editions.
Plantin G. and Shin. H.S. (2008) - Carry Trades and Speculative Dynamics, available at
SSRN: http://ssrn.com/abstract=898412.
Vistesen, Claus (2009) - Of Low Yielders and Carry Trading – the JPY and CHF as Market Risk Sentiment Gauges, Working Paper 06-2008
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[1] Basically, the regressions suffer from heteroscedasticity in the full sample. This need not be a severe problem for the overall result since the f-stats and standard errors are large and correspondingly small. Also, I am not really interested in the full sample, but in parameter stability across two distinct periods. Pre crisis and post crisis. The problem arises here since the tests we have to check for parameter stability (Chow tests, dummy approach as well as the simple one) are of course sensitive to unequal variances in the chosen period intervals.
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Reader Comments (7)
raimo1@hot.ee
CHINA GOLD
Die Volksrepublik China hat ihre Goldreserven seit dem Jahr 2003 von 600 auf 1.054 Tonnen aufgestockt. Das teilte der Leiter der Verwaltung der Währungsreserven, Hu Xiaolian, der chinesischen Nachrichtenagentur Xinhua mit.
Peking hatte in den vergangenen Jahren keine präzisen Angaben über seine Goldreserven gemacht. Marktkenner vermuteten allerdings schon länger, dass Peking seine Reserven ausbauen würde. Der Goldpreis legte am Freitag in Reaktion auf die Meldung aus China leicht zu. Kurz nach Eröffnung des New Yorker Handels kostete die Unze dort 908 Dollar. Der HUI-Index (Amex Gold Bugs Index) führender Goldminenwerte verbesserte sich zu Handelsbeginn um 3 Prozent auf 299 Punkte. Ende März hatte der Index noch 342 Punkte erreicht.
Leichte Diversifizierung der riesigen Währungsreserven
Wie Hu Xiaolian sagte, erfolgte der Reservenaufbau überwiegend durch Käufe von in China selbst gefördertem Gold. China gehört seit Jahren zu den wichtigsten Förderländern der Welt. Mit ihren Reserven von 1.054 Tonnen übertrifft die Volksrepublik die Schweiz, die Reserven von 1.040 Tonnen ausweist. Innerhalb der chinesischen Währungsreserven von rund 2.000 Milliarden Dollar spielt Gold aber nach wie vor nur eine bescheidene Rolle: Der Marktwert der Goldreserven beträgt lediglich gut 30 Milliarden Dollar
raimo1@hot.ee
BANK REFORMS-DOLLAR UND EURO REFORMS
The International Monetary Fund's (IMF) managing director has said the US and Western Europe need to act more quickly to sort out their banking systems.
Speaking in Washington before a series of high-level financial meetings, Dominique Strauss-Kahn said there had been progress but it had been too slow.
Mr Strauss-Kahn said cleaning up the mess in the financial systems of the rich world was the most important task.
But more action was needed to sort out problems with bad loans, he said.
He accepts that there has been progress. But he says it is not enough.
"In many countries the architecture of a coherent financial programme is now more or less in place. What is lagging, and where time has been lost, is in the implementation," he said.
His call was directed mainly at the United States and Western European countries.
Sorting out the banks was essential he said, if there is to be an economic recovery.
"All the experience we have of past banking crises, and we have a lot of experience with those banking crises in this institution, is that you never recover before you have completed the cleaning up of the balance sheet of the financial sector," he said.
Mr Strauss-Kahn will have an opportunity to press finance ministers on that over the next few days at a series of meetings in Washington.
In one area, he said was pleased with progress.
The stimulus from governments in tax cuts and extra spending for this year, Mr Strauss-Kahn said, is in line with what the IMF called for, though he suggested more might be needed in 2010.
raimo1@hot.eee
BRITISH CHRISE
Equally, it may be true that British GDP will be lower than the government forecasts by the middle of the next decade - credit crunches are much harder to slip away from than the government forecasts. But after the stimulus the economy has received, there should be some growth, broadly corresponding to the shape the Treasury predicts.
The real issue is the evaporation of our economic and political pretensions. The Treasury has been forced to recognise that 5% of Britain's GDP has disappeared forever. Too many industries were dependent upon the crazy world of ever-rising house prices and easy credit; now gone for ever. This means that the path to sustainable public finances is going to be astonishingly painful. We can live with national debt doubling, but it cannot double again.
The numbers are terrifying. Budget deficits, even for Keynesian apostles of deficit finance like me, cannot stay at 12% of GDP, or £175bn, for very long, however justifiable in recession. The problem is that so much economic capacity has permanently disappeared, along with those parts of the economy that used to deliver rich tax revenues; the post-recession economy will only reduce the deficit by a quarter. The rest has got to be found by tax increases or reductions in planned spending.
raimo1@hot.ee
CHINA GOLD
Die Volksrepublik China hat ihre Goldreserven seit dem Jahr 2003 von 600 auf 1.054 Tonnen aufgestockt. Das teilte der Leiter der Verwaltung der Währungsreserven, Hu Xiaolian, der chinesischen Nachrichtenagentur Xinhua mit.
Peking hatte in den vergangenen Jahren keine präzisen Angaben über seine Goldreserven gemacht. Marktkenner vermuteten allerdings schon länger, dass Peking seine Reserven ausbauen würde. Der Goldpreis legte am Freitag in Reaktion auf die Meldung aus China leicht zu. Kurz nach Eröffnung des New Yorker Handels kostete die Unze dort 908 Dollar. Der HUI-Index (Amex Gold Bugs Index) führender Goldminenwerte verbesserte sich zu Handelsbeginn um 3 Prozent auf 299 Punkte. Ende März hatte der Index noch 342 Punkte erreicht.
Leichte Diversifizierung der riesigen Währungsreserven
Wie Hu Xiaolian sagte, erfolgte der Reservenaufbau überwiegend durch Käufe von in China selbst gefördertem Gold. China gehört seit Jahren zu den wichtigsten Förderländern der Welt. Mit ihren Reserven von 1.054 Tonnen übertrifft die Volksrepublik die Schweiz, die Reserven von 1.040 Tonnen ausweist. Innerhalb der chinesischen Währungsreserven von rund 2.000 Milliarden Dollar spielt Gold aber nach wie vor nur eine bescheidene Rolle: Der Marktwert der Goldreserven beträgt lediglich gut 30 Milliarden Dollar.
raimo1@hot.ee
BaYErn LB bank
Es geht um die Zukunft einer Bank und ihrer vielen Beteiligungen, die sie in den vergangenen Jahren für viel Geld gesammelt hat. Und darum, dass vieles von dem nun auf der Kippe steht.
In Brüssel hieß es zuletzt, auf die BayernLB kämen "kräftige Auflagen" zu. Beteiligungen im Ausland sollen wegfallen, das Kapitalmarktgeschäft wird eingedampft, möglich ist auch, dass sich die BayernLB von ganzen Einheiten trennen muss.
Die Bank, die 2008 Verluste von über fünf Milliarden Euro einfuhr, muss in den nächsten vier Jahren 5600 der knapp 20.000 Stellen im Konzern kappen. Nur wo - das ist die Frage.
Noch hofft Kemmer, dass er die Stellen mit feinchirurgischen Schnitten möglichst schmerzlos los wird. Käme es hart auf hart, müsste er sich von ganzen Töchtern trennen. Von der Kärntner Osteuropa-Bank Hypo Alpe Adria (HGAA) etwa, die in 2008 einen Verlust von über 500 Millionen Euro einfuhr und wie die Mutter gestützt werden muss.
The Board of Investments (BoI) expected Malacañang’s approval of the yearly list by the end of last month but petitions from various sectors for changes in the list that Malacañang ordered to be heard delayed its signing, Trade and Industry Secretary Peter Favila said.
Favila said the BoI had to conduct new hearings for the late petitions despite the BoI completing all public hearings along with involved government agencies on the list as early as February this year.
“The IPP has been completed and the President has to sign it,” Favila said.
Favila, however, declined to explain what specific areas of the draft IPP were changed during the Malacañang-initiated hearings.
Favila was also asked if the President will sign the IPP before she leaves for Egypt today but he quipped “I do not ask the President for commitment.”
Initially, the BoI said the 2009 IPP focuses on the granting of incentives to all domestic micro, small and medium enterprises that would include the smallest type of projects such as sari-sari stores and three-wheel vehicles operators.
The scheme is part of plans drafted by the BoI along with other government agencies in line with a directive from the Arroyo administration to safeguard jobs and attract investments while the country suffers from the effects of the global financial slowdown.
BoI managing head and Trade Undersecretary Elmer Hernandez earlier said the new IPP may include new types of incentives that are still in the process of discussions by the IPP inter-agency committee.
Europa in der Rezession
Deutschland wird in der Wirtschaftskrise wieder zum Defizitsünder. Entgegen früherer Prognosen bricht Berlin schon im laufenden Jahr mit einer Neuverschuldung von 3,9 Prozent den Euro-Stabilitätspakt, wie die EU-Kommission am Montag in Brüssel vorhersagte.
Im kommenden Jahr drohen 5,9 Prozent Defizit vom Bruttoinlandsprodukt. Europa steckt mitten in der tiefsten Rezession seit dem Zweiten Weltkrieg. Das Heer der Arbeitslosen wächst. Ein leichter Hoffnungsschimmer zeichnet sich für 2010 ab.
Bundesfinanzminister Peer Steinbrück sagte in Brüssel zum europäischen Arbeitsmarkt: «Das macht mir Sorge.» Es sei kein Trost, dass die Lage in Deutschland wegen der Reformen der vergangenen Jahre besser aussehe. Laut Kommission werden 2009 und 2010 insgesamt 8,5 Millionen Jobs in der EU verschwinden. Die Arbeitslosenquote soll im kommenden Jahr im Eurogebiet auf 11,5 Prozent steigen nach 9,9 Prozent im laufenden Jahr. Deutschland schneidet mit 10,4 Prozent (2010) und 8,6 Prozent (2009) etwas besser ab.