While the dollar’s ongoing rally has grabbed most headlines, the market seems to be catching on to the other big trend in currencies: the distinct breakdown in the carry trade. The deterioration in the yield-based strategy is partially rooted in a rise in risk aversion; but warped risk / reward is likely the greater driver for the recently volatile FX market.
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• Carry Trade Plunges, But Yen Pairs Testing Support
• Interest Rate Expectations Grow Increasingly Skewed
• Currency Market Volatility Rebounds As Carry Pairs Lose Direction[/B]
While the dollar’s ongoing rally has grabbed most headlines, the market seems to be catching on to the other big trend in currencies: the distinct breakdown in the carry trade. The deterioration in the yield-based strategy is partially rooted in a rise in risk aversion; but warped risk / reward is likely the greater driver for the recently volatile FX market. This past week, the DailyFX Carry Trade Index fell 126 points to 27,811 – notable in the decelerated pace of the drop compared to previous week but also that it is a new multi-month low. Reflecting the extent of the move through the past few weeks, fear measured in the Volatility Index has also picked up back above the key 10 percent figure. The outlook for direction is clearly catching up to the activity in spot with USDJPY risk reversals pull back to 3.11.
From testing six-month highs only a few weeks ago, the carry trade has sense tumbled to multi-month lows. However, this sharp drop in the coveted yield strategy doesn’t seem to be just another round of risk aversion. In fact, optimism has actually been spurred on by a recovery in equity markets across the West as well as the relief felt in the sharp reversal of commodity prices. On the other hand, news and data still reflects a lack of liquidity in the credit market and ongoing problems for the financial sector. For banks, a deceleration in global growth and ongoing write downs on mortgage derivatives are now being joined by forced repurchases of auction rate debt. The derivatives were sold to clients before liquidity seized and a market virtually disappeared, leading regulators to swoop in. Altogether, the rising problems in the financial sector and the jump in volatility across the asset spectrum (even if that volatility is derived from a drop in commodity prices) are unfavorable conditions for any strategy that makes a steady income from stable markets. A different concern is the outlook for interest rate differentials (the return component of carry’s risk/reward). While expectations for the BoJ are for no change, the Fed is expected to begin a series of rate hikes while central bank’s for high-yielding countries are forecasted to institute deep cuts.
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[B]Risk Indicators:[/B]
[B]Definitions[/B]:
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[B]What is the DailyFX Volatility Index: [/B]
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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.
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[B]What are Risk Reversals:[/B]
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 USDJPY as it is the benchmark yen pair and the Japanese currency is considered the proxy funding currency for carry trader. When Risk Reversals grow more extreme to the downside, there is greater expectations for the yen to gain – an unfavorable condition for carry trades.
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[B]How are Rate Expectations calculated:[/B]
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Forecasting rate decisions is notoriously speculative, yet the market is typically very efficient at predicting rate movements (and many economists and analysts even believe the market prices influences 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 Bank of Japan will make over the coming 12 months. We have chosen the Bank of Japan as the yen is considered the proxy funding currency for carry trades.
To read this chart, any positive number represents an expected firming in the Japanese 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 contract and carry trades will suffer.
[B]Additional Information[/B]
[B]What is a Carry Trade
[/B]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.
[B]Carry Trade As A Strategy[/B]
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.