Working Notes: Carry Trade
Wednesday, October 11, 2006 at 09:21PM I have posted on carry trade several times on Alpha.Sources; more specifically three times:
The ultimate "yen carry-trade" guide
Carry trading and markets at a glance
Brad Setser: Carry traders and today's currency markets
However, my impetus for this post at Beta.Sources is an excellent Buttonwood column in The Economist about carry trade. The article is posted in its full length below.
IT IS very hard for people to resist instant gratification. That explains why the carry trade, borrowing at a low rate to buy high-yielding investments, is so common today. It offers immediate rewards.
Because Japanese interest rates are a lowly 0.25%, the yen is widely assumed to be the basis for many carry trades. But, as Tim Lee of pi Economics, a consultancy, points out, the practice is much more widespread; in eastern Europe, many companies and individuals borrow at a lower rate in foreign currencies in order to buy property.
It is a bit like “maxing out” on your credit cards. The reward arrives immediately while sometimes it seems the bill can be indefinitely postponed. But, alas, payment will eventually come due.
The carry trade is essentially a bet on lower volatility. To take an outright gamble that markets will barely move, an investor would write (sell) options; this approach would bring in premium income, but would lose money if prices changed enough for the options to be worth exercising. In the foreign-exchange version of the carry trade, an investor receives an income by borrowing a low interest rate currency and owning a higher-yielding one. This produces a positive return most months, but the risk is that the high-rate currency will devalue, resulting in a heavy loss.
Cynics have described these bets as “picking up nickels in front of steamrollers”. A long series of small gains is punctuated by the occasional wipe-out. However, from the point of view of a hedge-fund manager, it is a perfectly rational approach.
Amaranth Advisors, the hedge fund that lost a bundle speculating on natural-gas futures, is not a typical example of the modern hedge fund. These days, hedge funds like to market themselves as a way to diversify pension-fund (and other institutional) portfolios. That requires them to produce nice, smooth returns that can be plugged into the models of investment consultants. Carry trades fit the bill.
In contrast, betting against the carry looks a far less attractive business proposition. Such a strategy would lose money most months, only to make big gains when devaluation (or a sudden burst of volatility) occurred. That kind of return would look very “risky”, even though the long-term net result would probably be identical to that produced by the carry trade (Nassim Taleb, author of “Fooled by Randomness”, argues the returns would be greater because the likelihood of extreme events is underestimated).
As a consequence, investors tend to switch to a “negative-carry” approach only when the trend is already moving in that direction. In theory, this could lead to very sharp reverses in trend once the carry trade starts to deteriorate.
Fortunately for carry-trade investors, volatility has been very low in the past couple of years. A recent Bank for International Settlements paper* tries to explain why. Part of the explanation may be the lower volatility of economic fundamentals such as inflation and GDP growth; another part results from the improvement in corporate profits and balance sheets; a further part from the greater transparency of monetary policy; and a final part from innovation in financial markets, notably the growth of hedge funds (which have improved liquidity) and the development of derivatives (which have allowed risk to be spread more widely).
Are any of these developments permanent rather than cyclical? Volatility tends to be highest when recessions occur and, although the business cycle has been extended, it has not been abolished. An economic downturn would also hit companies. And it is easier for monetary policy to be transparent and for central banks to seem all-knowing when economic conditions are benign; much harder when (as globally in the 1970s or in Japan in the 1990s) times are hard. Even the liquidity of financial markets tends to deteriorate when money is tight and asset prices are falling.
But the important point is that financial markets are a complex adaptive system, in which the actions of participants affect the fundamentals. The best analogy might be the “seat belt” attitude to risk. In theory, having seat belts in cars should save lives. But the presence of seat belts may cause motorists to drive faster, leading to no improvement in road safety. That has led some to theorise that people have a mental budget for risk; if it is reduced in one area, they will compensate by taking more risk in another.
Thus the low level of volatility may make investors overconfident, taking on more risk either by buying exotic investments or by using debt to finance their positions. When bad news does occur, those investors will be dangerously exposed. Low volatility and the carry trade sow the seeds of their own destruction.
See also this BIS paper linked by the Buttonwood column.
A striking feature of financial market behaviour in recent years has been the low level of price
volatility over a wide range of financial assets and markets. The issue has attracted the
attention of central bankers and financial regulators due to the potential implications for
financial stability. This paper makes an effort to shed light on this phenomenon, drawing on
literature surveys, reviews of previous analyses by non-academic commentators and
institutions, and some new empirical evidence.
The paper consists of seven sections. Section 2 documents the current low level of volatility,
putting it into a historical perspective. Section 3 briefly reviews the theoretical determinants of
volatility, with the aim of helping the reader through the subsequent sections of this Report,
which are devoted to the explanations of the phenomenon under study. These explanations
have been grouped into four categories: real factors; financial factors; shocks; and monetary
policy. Thus, Section 4 looks into the relation between volatility and real factors, from both a
macro- and a microeconomic perspective. Section 5 considers how the recent developments
in financial innovation and improvements in risk management techniques might have
contributed to the decline in volatility. Section 6 considers the relation between real and
financial shocks and volatility. Finally, Section 7 explores whether more systematic and
transparent monetary policies might have led to lower asset price volatility.
As a final note carry trade is very difficult to talk about without also talking about the Yen and Japan since most carry trade is deemed to be in Yen as the carrying currency. As such, most references above also tackle this issue from a Japanese point of view.
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