Though it is a relatively tentative rise, risk trends seem to be broadly improving. The DailyFX Carry Trade Index has maintained the upward trajectory that has held since the March reversal. What’s more, a look to the details underlying this advance reveals most of the general conditions surrounding risk appetite are improving. The DailyFX Volatility Index shows price action is stabilizing into its steady rally with expected fluctuations for the coming three months cooling to 2.88 percent. As for the outlook for USDJPY (the carry trade proxy), interest is shifting to bullish calls even as speculation that a BoJ rate hike is in the pipeline gains traction.
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• Rebound In Carry Interest Measured As Traders Weigh Credit, Fundamental Conditions
• Risk Appetite Rising As Global Growth Trends Reflecting Little Of The Financial Turmoil
• Divergence Between Carry And Other Risky Assets Prominent[/B]
Though it is a relatively tentative rise, risk trends seem to be broadly improving. The DailyFX Carry Trade Index has maintained the upward trajectory that has held since the March reversal. What’s more, a look to the details underlying this advance reveals most of the general conditions surrounding risk appetite are improving. The DailyFX Volatility Index shows price action is stabilizing into its steady rally with expected fluctuations for the coming three months cooling to 2.88 percent. As for the outlook for USDJPY (the carry trade proxy), interest is shifting to bullish calls even as speculation that a BoJ rate hike is in the pipeline gains traction.
Looking beyond general market conditions, the fundamentals of the past few weeks certainly offer some perspective into the general rebound in risk appetite and why the carry trade has not returned to the forefront of the yield hunt. First, looking outside the currency market, there has been a clear reversal in the demand for yield seen with the steady advance in equities, strength in speculative commodities, a rise in bond yields and sharp reversal in credit spreads. Recently, this has been supported by global GDP numbers that have consistently bested the market’s dour forecasts. This is an unusual outcome for most economists and market participants as the severity of the credit market crisis had reached a fever pitch through the first quarter; and the effects were expected to hit economic expansion hard. Policy makers at the major central banks have been the main source for relief as the demand for liquidity has been largely satiated by aggressive injections. At the same time though, the rebound in carry has somewhat lagged the strength in other markets suggesting investors are far more cautious of risk with the fallout from the credit crunch still fresh in most traders’ minds.
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Carry Basket Component Currencies:
[B]Risk Indicators:[/B]
[B]Definitions[/B]:
[B]What is the DailyFX Volatility Index (VIX): [/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 are greater for puts than for calls (as implied volatility for puts is quoted as a negative percentage and implied volatility for calls is quoted as a positive percentage) 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.
Additional Information
What is a Carry Trade
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.
Carry Trade As A Strategy
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.
[I]Written by: John Kicklighter, Currency Analyst for DailyFX.com
We love feedback! To contact John about this or other articles he has authored, you can email him at <[email protected]>.[/I]