Part I will focus on discussing the Zero Hedge model of the carry trade, the common fallacies out there about the carry trade and the current inefficiencies in the market
Part III will cover the outlook of the carry trade, a high level game plan based on the Zero Hedge approach and what not to do.
Since Zero Hedge only received naughty emails when we posted for space monkeys on Craiglist, I'm relying on external research to supply some of the numbers. You can read this if you really want to get into the weeds but be warned, it's a little heavy.
Part I - Project Runway: The Zero Hedge Model
Overview: The Zero Hedge model can be just as easily defined by what it isn't than by what it is. The academic perspective of the carry trade can typically be expressed as some form of the uncovered interest rate parity hypothesis (UIP) - basically, the efficient markets/"hey, if it was so profitable everyone would be doing it" school of academic financial thinking. Basically, there are two drivers of returns in the carry trade: a) the interest differential between two currencies (i.e. AUD/JPY is a popular one, look at a time series of the two respective gov't rates) and b) the delta in appreciation of the investment currency vs. the funding currency. UIP basically states that any profit from a) is offset by a loss in b) - that investment currencies will decay/depreciate against funding currencies in such a way as to net out the profit. The defenders of UIP typically say that in practice, the expected decay comes in spurts so that it eventually nets out to roughly the same thing. However, the reality is that the market is much more predictable than that and with moderate leverage, if you hop on the carry trade at the right time you can ride it through for some performance gains. Much like the trend riders of the Chicago pits in the 70s and 80s, a carry trader recently has been able to book some pretty solid gains on a relatively stable risk basis - to put some numbers on it, a basic 3 long/3 short strategy over a 20 year period has typically netted about a 0.78 Sharpe ratio. Those kind of numbers are typically reserved for some of the bigger names in investment management.
In terms of the business cycle concept, a typical carry trade will go as follows from the academic equilibrium. Some sort of shock (endogenous or otherwise) will jar the investment currency up a few notches on the interest differential scale (with respect to the funding currency). Followed by that, the investment currency may engage in a brief sell-off as the scalpers and news traders take profits. Next the investment currency slowly appreciates against the funding currency as carry traders pile in and smooth out a lot of the depreciation predicted by the UIP hypothesis (hint: this is why JPY and CHF are "safe havens" in today's environment). The combination of the interest rate differential and long-term trend of investment currency appreciation draws in more carry traders and the investment currency gains until the inevitable popping of the carry trade bubble. What is interesting is that if one knows anything about the carry trade market, the drivers and the underlying psychology it's not hard to step out of the way when investor sentiments shift for any one of the usual reasons. The mistake most carry traders make is focusing externally at the macro factors that may depreciate their investment currency. Of course, even if you are keenly attuned to the carry trade internal machinations, you are still left with the typical "well I know I should get out but everyone else is still holding so I may as well squeeze out some more money" response. That's when the "good trader" instincts need to kick in, discipline needs to be maintained, fight clubs to be attended, etc. Hey - no one said this would be easy.
A quick note on the inefficiencies. As humans, we have a predilection towards negatively skewed asset classes - this has been discussed by a few including Nassem Taleb. The positive reinforcement of seeing steady gains on your investment inevitably leads to an inefficient allocation towards negatively skewed assets. In carry trade terms, there are a few currencies with a positive interest rate differential with respect to the dollar AND a positively (or only very slightly negatively) skewed risk profile including the NOK, GBP and EUR. I'll leave it to you to derive the trade idea.
Another inefficiency manifests itself right after a crash in the carry trade markets. Right after a crash, carry insurance is at its most overpriced. This is a manifestation of the excessively externally-focused mindset of carry traders. After a carry crash, a lot of the air in the balloon gets let out and a savvy investor can pick up a few additional pennies by selling carry insurance. Most buyers of carry insurance tend to be skittish of further macro trends so they overpay - as before, you can express this in a lot of different way, either through a synthetic option structure or an OTC forward.
7 comments:
I think using open interest at the Tokyo futures exchange is a decent way of measuring the frothiness of the trade if you want to build a timing indicator to tell you when to exit.
Why don't your blog posts come out properly in Google Reader anymore? Just the headlines come out as opposed to the body of the text like it used to.
Thanks for fixing the headlines thing..
I think Deutsche Bank was running a strategy that would unwind a basket of FX carry trades if short-term vol spiked up compared to longer-dated vol. I think you could even buy structured notes where the returns were tied to profitability of the strategy.
looking forward to more info. Here is an old Naive traded forex index I am updating. http://nickgogerty.typepad.com/designing_better_futures/files/GO.pdf
The Romanian RON has one of the highest interest rates in Europe - 10%. From January to now it has been very steady, after a 20% depreciation since September. It's much flatter than the Polish Zlot (PLN) or the Hungarian Forint (HUF).
Do you believe, if you have an opinion on this, that it could be because of carry trade?
Danske Bank has been predicting for almost two months now a further 10% depreciation, but it didn't happen. SocGen recently announced closing it's short RON position.
I'm very interesting on your thoughs about CEE currencies.
Yes and no - the carry trade in Eastern Europe isn't so much through the spot or forwards markets but through all the houses bought with CHF. There may be speculators representing a position on the spot/forwards markets but the numbers are small enough to not crush the market when liquidity and vol appetite dries up.
The Eastern European currencies are an interesting study - I'm considering doing a longer post on them later.
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