The carry trade has maintained its upward trajectory, but the popular strategy has certainly lost steam. The DailyFX Carry Trade Index rose modestly since last week to 28,928 – though this advance merely lifts the basket to the top of a developing congestion zone and more importantly to the significant downward sloping trendline that has defined sentiment since last summer. Looking at broader risk trends, this divisive trendline may hold up to any further carry rebound. Capital markets have already marked a sharp reversal while fear has boosted volatility and demand for puts. However, the DailyFX Volatility Index shows market activity is still near its lowest levels since February. Furthermore, the outlook in option markets still shows a considerable bias towards USDJPY calls.
• Rebound In Carry Trade Hits Resistance As Risk Appetite Falters
• Sharp Downturn In Equities Threatens To Weigh On All Risky Assets
• Volatility And Other Market Conditions Catching Up To Turn In Price
The carry trade has maintained its upward trajectory, but the popular strategy has certainly lost steam. The DailyFX Carry Trade Index rose modestly since last week to 28,928 – though this advance merely lifts the basket to the top of a developing congestion zone and more importantly to the significant downward sloping trendline that has defined sentiment since last summer. Looking at broader risk trends, this divisive trendline may hold up to any further carry rebound. Capital markets have already marked a sharp reversal while fear has boosted volatility and demand for puts. However, the DailyFX Volatility Index shows market activity is still near its lowest levels since February. Furthermore, the outlook in option markets still shows a considerable bias towards USDJPY calls.
The correlation between the carry trade and other risk-sensitive assets will be put to the test over the coming weeks and months. We have seen recently that the tight connection between the carry trade, equities and other high-yielding instruments - that was so strong through the subprime meltdown and credit crunch - has faded with investors slowly moving out of highly liquid assets and back into those that actually provide return. If the correlation continues to hold, the considerable reversal in equities may foreshadow a similar drop in the yen crosses. On the other hand, this equities’ reversal has yet to turn speculative futures, raise risk premium in default swaps, or alter underlying trading conditions. In fact, volatility in the equities market (as measured by the VIX) has risen little from its recent 10-month low and the put-call ratio continues to hit new lows for the year. This notable divergence suggests equities are merely following economic trends (speculation the Fed is done lowering rates) and risk trends may no longer be a market wide influence.
[I]Is Carry Trade a Buy or a Sell? Join the DailyFX Analysts in discussing the viability of the Carry Trade strategy in the DailyFX Forum[/I]
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[B]Risk Indicators:[/B]
[B]Definitions[/B]:
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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 (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]
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.
[I]For additional resources, check out the DailyFX Forum[/I]
Have comments or questions on this or other articles authored by John? E-mail him at <[email protected]>.