When it's a risky time for the 'safe bet' carry trade
news.ft.com
By Christopher Swann in London
Published: October 31 2002 4:00 | Last Updated: October 31 2002 4:00
Many currency dealersview the carry trade as the closest thing there is to a sure bet.
The trade involvesborrowing and then selling a low-yielding currency such as the yen, and parking the funds in a currency offering high interest rates.
The trader then picks up a juicy interest rate pay-off and - in the happy event that the low-yielding currency falls in value - a capital gain, too.
But there is no such thing as a free lunch. Such trades occasionally end in disaster.
A fall in the value of the high-yielding currency can obliterate the interest rate gain and on occasion lead to big losses.
The most notorious example of this was in October 1998 when the dollar fell almost 14 per cent against the yen in a week. A large number of financial institutions, which had sold the yen short in order to fund investments in the US Treasury market, were forced to buy back the Japanese currency at a huge loss.
The financial fall-out was so great that it pushed the UK balance of payments into temporary surplus in the third quarter of 1998, as foreign institutions were forced to inject funds into their London operations to cover heavy losses on carry trades.
After such a calamity it is small wonder that investment banks have devoted so much energy to researching carry trades in order to minimise such risks.
Theoretically, the carry trade should not work at all. According to the theory of uncovered interest rate parity, arbitrage should prevent any gains being made from rate differentials between currency zones. The returns from currencies should equal out, so that a low-yielding currency will appreciate to compensate investors for its more modest returns.
The reality is different. A huge volume of empirical research has demonstrated that carry trades do tend to pay off.
One possible reason is that, in general, riskier currencies - those with large current account deficits - are forced to offer a higher interest rate to compensate investors for the risk of a sharper depreciation than that predicted by uncovered interest rate parity.
The profit from a carry trade is investors' payment for taking this risk.
This philosophy lies behind the approach of JP Morgan in maximising returns from carry trades.
Carry trades are more likely to go wrong in times of risk aversion. In such times, the riskier currencies - upon which carry trades rely for their returns - tend to depreciate. Typically, riskier currencies have current account deficits and, as risk appetite wanes, investors retreat to the safety of their home markets, making these deficits harder to fund.
"It makes sense to unwind carry trades in times of rising risk aversion, since adverse currency moves tend to at least partly offset the interest rate advantage," says Paul Meggyesi, currency strategist at JP Morgan.
Most banks now have their own early warning system of rising risk aversion - normally comprising emerging market bond spreads, swap spreads and equity market volatilities - which can alert traders when they need to get out of carry trades.
Another way of boosting returns on carry trades is by diversification. Instead of using one low-yielding currency to invest in one high- yielding currency, it is better to hedge your bets.
Researchers at Deutsche Bank recently calculated returns from various carry trade strategies using the currencies of the 10 leading industrialised nations. The lowest return came from the simplest approach, which involved simply shorting the lowest yielding currency to fund investments in the highest yielding currency. Between 1995 and 2002, around 63 per cent of the interest rate gains from such a strategy would have been lost through adverse currency movements.
The optimal strategy, they discovered, was to invest in the top two highest yielders and fund the position by selling the three lowest yielders.
There will always be occasions when carry trades go wrong. But through diversification and paying close attention to levels of risk aversion, the threat can be reduced. |
