Monday, March 23, 2009

The Carry Trade (1 of 3): The Zero Hedge view

Let's talk about the carry trade. I'll be putting out a 3 part series on the carry trade at a medium level of proficiency (i.e. you don't need to be a finance PhD) and will explain why it's especially pertinent now.

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 II will discuss the past 6-7 years of the carry trade in the context of the Zero Hedge model, how it happened and some of the lessons (e.g. the "safe haven" theory in the current situation despite the fact that the Swiss are just as screwed as the rest of us and the yen isn't that much better).

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.

Additionally, academics and even some carry traders believe that if the carry trade were an entity, it is merely along for the ride as the markets instantly and efficiently respond to the fundamental factors we all know and love. Most smart money disagrees - the carry trade is a case where the tail wags the dog and subsequently the most publicized/seemingly unrelated factors such as lowered liquidity and increased volatility/lowered risk appetite typically results in crashes in popular carry markets. Zero Hedge believes that there are many more factors that is carry trade idiosyncratic but the two just mentioned will do for the purposes of this discussion. In technical terms, currency futures(t) and futures (t+1) are negatively correlated to delta VIX with futures(t) figures at -1.47 with a 0.77 SE adjusted for serial correlation and futures(t+1) at -1.29 with a 0.57 SE. If you didn't understand that last sentence, just take my word for it. Of course this idea of carry trades affecting markets is not new - it was a serious concern at those G7 conferences in 2005/2006 and was still coming up in discussions in 2007, as the rumblings of the credit crunch began. However, the concern in those cases was primarily focused on a rapid unwind based on macro conditions and the carry trade amplifying that NOT because of the impact of carry trade-specific factors.

Ok fine - how about saying what IS the Zero Hedge model for a change? The best way to think about the carry trade is to think of it as a distinct asset class that follows its own version of the business cycle. As an asset class, the carry trade is susceptible to negative fat tails, reliant on cheap funding, and positively benefitting from a low risk environment (sound like anything else you may have heard of?). In common with other negatively skewed (negative fat tails), highly leveraged asset classes, the carry trade will fall off the cliff lemming-like at the first sign of a big negative shock as a huge pile of investors suddenly find themselves trying to squeeze out of a shrinking door as valuations plumment and margin calls are sprayed like a firehose at a wet Tshirt contest. In practicality, this is made much worse as many of the individual investor carry traders don't bother with tight stop-losses as the combination of the high leverage they need to generate a meaningful return combined with the typical vol of FX would mean a series of fake stop-outs before the market whipsaws back in the black.

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.

As a portfolio manager, the carry trade is clearly a strong addition as an asset class to your portfolio and should be treated as such. If you approach portfolio construction from an asset class characteristic model that can handle actively managed asset classes, the carry trade can definitely juice some portion of your portfolio in an uncorrelated way and on a good risk-adjusted basis (of course depending on your main strategy). There is much more nuance to the Zero Hedge model and if there is demand for it, I can cover it later. Sphere: Related Content
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Ian said...

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.

Anonymous said...

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.

Anonymous said...

Thanks for fixing the headlines thing..

Alex said...

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.

Anonymous said...

looking forward to more info. Here is an old Naive traded forex index I am updating.

Anonymous said...

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.

Cornelius said...

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.