Carry trade

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Contents

Overview

The carry of an asset is the return obtained from holding it (if positive), or the cost of holding it (if negative).

For instance, commodities are usually negative carry assets, as they incur storage costs, but in some circumstances, commodities can be positive carry assets as the market is willing to pay a premium for availability.

This can also refer to a trade with more than one leg, where you earn the spread between borrowing a low carry asset and lending a high carry one.

Carry trades are not arbitrages: pure arbitrages make money no matter what; carry trades make money only if nothing changes against the carry's favor.

Evidence of the carry trade activity

Interest rate differentials have been a driving force behind exchange rate movements in recent years.

This has focused market attention on the role of currency carry trade positions, and on the possibility that a sudden unwinding might adversely affect financial stability.

However, carry trades are notoriously difficult to track in the available data. This special feature first outlines the investor base and trading strategies used in carry trades, and then explores various sources of data to gauge activity.

We explain the currency carry trade performance using an asset pricing model in which factor loadings are regime-dependent rather than constant.

Empirical results show that a typical carry trade strategy has much higher exposure to the stock market and is mean-reverting in regimes of high FX volatility.

The findings are robust to various extensions.

Our regime-dependent pricing model provides significantly smaller pricing errors than a traditional model.

Thus, the carry trade performance is better explained by a time-varying systematic risk that increases in volatile markets, suggesting a partial resolution of the Uncovered Interest Rate parity puzzle.

Interest rates

For instance, the traditional income stream from commercial banks is to borrow cheap (at the low overnight rate, i.e., the rate at which they pay depositors) and lend expensive (at the long-term rate, which is usually higher than the short-term rate).

This works with an upward-sloping yield curve, but it loses money if the curve becomes inverted. The floating of short-term rates, for example, when Paul Volcker was the chairman of the Federal Reserve resulted in exactly this problem and was an important cause of the Savings and Loan crisis.

According to a popular anecdote, traditional commercial banking was characterized as a "3-6-3" business: borrow at 3%, lend at 6% (thus earning the 3% spread), be on the golf course by 3 pm.[1] While this may have been close to the truth in the market of the 1950s to the 1970s, the modern competitive market ensures that profits are kept more in line with perceived risks.

Currency

The term carry trade without further modification refers to currency carry trade: investors borrow low-yielding currencies and lend (invest in) high-yielding currencies. It tends to correlate with global financial and exchange rate stability, and retracts in use during global liquidity shortages. [2]

The risk in carry trading is that foreign exchange rates may change to the effect that the investor would have to pay back more expensive currency with less valuable currency.[3]

In theory, according to uncovered interest rate parity, carry trades should not yield a predictable profit because the difference in interest rates between two countries should equal the rate at which investors expect the low-interest-rate currency to rise against the high-interest-rate one. However, carry trades weaken the currency that is borrowed, because investors sell the borrowed money by converting it to other currencies.

By early year 2007, it was estimated that some US$1 trillion may be staked on the Japanese yen carry trade.[4] Since the mid-90's, the Bank of Japan has set Japanese interest rates at very low levels making it profitable to borrow Japanese yen to fund activities in other currencies.[5]

These activities include subprime lending in the USA, and funding of emerging markets, especially BRIC countries and resource rich countries.

Known Risks

The 2008–2009 Icelandic financial crisis has among its origins the undisciplined use of the carry trade. The US dollar and the yen have been the currencies most heavily used in carry trade transactions since the 1990s. There is some substantial mathematical evidence in macroeconomics that larger economies have more immunity to the disruptive aspects of the carry trade mainly due to the sheer quantity of their existing currency compared to the limited amount used for FOREX carry trades.

Federal Reserve and the carry trade

"The Federal Reserve is still going through its "lessons-learned" exercise from the recent financial crisis, but there's one lesson it clearly has not yet absorbed -- the one about ignoring and enabling credit bubbles.

That's the only conclusion that can be drawn from the Fed's decision last week to not only keep its benchmark interest rates at zero but also let everyone know that it intends to leave them there for a good long time. In case anyone missed the message, Fed officials and other central bankers and finance ministers repeated their promise several days later at a meeting in St. Andrews, Scotland, where they vowed to not let up the gas pedals of fiscal and monetary stimulus. And on Tuesday, the point was driven home again by members of the Fed's policy panel in three separate speeches.

Not surprisingly, all of this sparked a week-long party in financial markets that had already experienced powerful rallies over the past six months. Even with Thursday's modest pullback on Wall Street, U.S. stocks are up 60 percent since March, and share prices in emerging markets have nearly doubled. Commodity prices are soaring once again, led by gold, which is now selling for more than $1,100 an ounce, and crude oil, which is up a whopping 126 percent since February. A rally in the junk-bond and third-world debt markets has driven interest rates back to where they were before the crisis. In urban China, India and Brazil, property prices have doubled in the past year.

"The markets are on a sugar high," Mohamed El-Erian, chief executive of Pimco, the giant money manager, told Newsweek's Rana Foroohar last week.

Judging from how sharply and quickly these prices have risen, it's a pretty good guess that most of the buying has not been done by long-term investors who are suddenly upbeat about the prospects of global economic growth. The better bet is all this is the handiwork of short-term speculation by banks, hedge funds, private-equity funds and other financial center wise-guys moving as a herd, financing their purchases directly or indirectly with some of that yummy zero-percent money provided courtesy of the Fed.

For many investors, in fact, the cost of money is effectively less than zero, as economist Nouriel Roubini likes to point out. If you borrow dollars at near zero percent interest in the United States, exchange the dollars for Thai bhat, and invest the bhat in government bonds paying 4 or 5 percent, you not only get the benefit of the interest rate arbitrage but you also gain when you sell the bond and exchange the bhat back into dollars that have since depreciated. Roubini calls it "the mother of all carry trades," and in recent months he calculates that it has been generating annualized returns for investors of 50 to 70 percent.

This carry trade is now so widespread that it has become a major factor driving down the value of the dollar against many other currencies and driving up the flow of hot money into a number of developing countries. Not only has it spawned stock, bond, or real estate bubbles in those countries, but it's also driven up the value of their currencies to the point that their exports are less competitive relative to countries, including China, that peg their currencies to the U.S. dollar. To counteract these trends, central banks in Thailand, South Korea, Russia and the Philippines have intervened in currency markets, buying up dollars and selling their own currencies. Hong Kong has tightened up on lending rules, while Brazil has put a 2 percent tax on capital inflows. Taiwan has banned foreigners from making certain types of bank deposits.

There's no way to know how long all this can continue before one of these bubbles finally bursts, the dollar spikes upward and investors all rush to unwind their trades at the same time. But it is a good guess that it will last as long as the Fed and other central banks indicate there is no end in sight for the current cheap-money regime. The longer they wait, the bigger the bubbles, and the bigger the mess to clean up.

All of which is why the recent statements by policymakers were so disappointing -- and so dangerous.

Despite the junk-bond and real estate bubbles of the late 1980s, the tech bubble and Asian financial crises of the 1990s and the credit bubble of recent years, the Fed stubbornly clings to an outmoded way of thinking and talking about the economy and monetary policy. Fed officials tend to give little weight to such "extraneous" factors such as asset prices, currency movements and capital flow, at least in public, and fear that focusing on them will cause them to lose sight of their core inflation-fighting mission. Moreover, like his predecessor, Fed Chairman Ben Bernanke still believes central bankers aren't smart enough to tell when a bubble has developed -- and even if they could, it would probably cause more harm than good to try to do something about it.

Janet Yellen, the president of the San Francisco Fed, is one of a small number of Fed policymakers who have begun to question the Fed's bubble orthodoxy, but even she declined to stray this week from the official line that the economy and the banks remain so weak that it is premature to even think about raising rates. That might make some sense if all this credit was flowing to worthy households and businesses. The evidence, however, suggests that much of it is going toward short-term financial speculation that is great for boosting bank profits and fattening the bonuses of Wall Street wise guys -- but lousy at producing sustainable long-term growth.

If there is one lesson to be drawn from the recent crisis, surely that is it."


References

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