Thursday, March 14, 2013

FX Carry Trade is Back

Uncovered interest rate parity suggests that currency returns should relate to interest rates in a pretty straightforward way. For example, the short-term interest rate in American dollars is about 0.25% and the comparable rate in Australia is 3.0%. According to the uncovered interest rate parity, the Australian dollar should depreciate against the American dollar by approximately 2.8%. Put another way, to convince an investor to invest in Australia when its currency depreciates an expected 2.8%, the Australian dollar interest rate would have to be about 2.8% higher than the American dollar interest rate.

On average, however, the high interest rate currencies actually appreciated.  If you borrow in low interest rate countries, invest in high interest rate countries, you simply make more money and no one has found a risk metric that might explain this. It's another example of the failure of the risk premium to appear where it should.  Here's Marty Eichenbaum in a short interview talking about his NBER paper on this subject.

Here I'm simulating the total return to going long the Australian Dollar and Brazilian Real, short the Japanese Yen and Swiss Franc, classic high  and low interest rate economies.

As one can see, this trade took a really big hit in 2008, but rebounded within a year unlike many other assets. However, since then it's been a boring trade. This year, however, it's been going gangbusters,so perhaps we are back to old times.  


Anonymous said...

So the carry trade crashed in 2008 (with the stock market), and it's doing great now (again, with the stock market).

Note that the yen crashed at the same time that the Japan stock market took off like a rocket.

If you just looked at 2008-present you would have no trouble at all explaining the returns of the carry trade. It seems premature to declare that it's "back"...

Mercury said...

“According to the uncovered interest rate parity, the Australian dollar should depreciate against the American dollar by approximately 2.8%.”

Over what time period? Instantly…or over some arbitrary length of time? Once you put a carry trade on you only care (aside from default risk) about the currency you’re long depreciating vs. the currency you’re short in excess of your borrow/lend spread. Even if the AUD does depreciate (in the above example) by the modeled 2.8% over some time period, you still make money if some of that depreciation happens on either side of your trade on/trade off window.

If the spread between borrowing for a year in USD and lending for a year in AUD is 2.8% and the AUD is depreciating vs. the USD at a steady, 2.8% per annum rate then there is nothing to exploit. But even then you could borrow short and lend long and in any case other market participants are doing different things all the time which means the two currencies aren’t going to move linearly vs. each other so I don’t know where this expectation of “parity” is coming from.

The real question it seems is why (if this is actually the case at any given time) does the cost of hedging (via puts, forwards etc) the carry trade not equal or exceed the interest rate spread? Shouldn’t market efficiency manifest itself in this area (on a case by case, trade by trade basis) instead of in the relationship between the two currencies which encompasses the sum total of all kinds of different transactions which may or may not mesh with your particular transaction?

Eric Falkenstein said...

The interest rate duration would dictate the period length for the currency move. Eichenbaum's paper sooks at augmenting this with puts.

historysquared said...

These "Capital Flow Bonanza's," in Rogoff and Reinhart's terms, are prone to rapid reversals.

In "Carry Trades and Currency Crashes," Brunnermeier, Nagel, Pedersen (2009) document the negative skew in the carry trade strategy, it has "crash risk."

Fundamentally, the capital flows have created credit bubbles across a geographically wide variety of countries, across latin america, asia, and parts of western europe, like the Nordic countries.

If you look at the literature, among the best leading indicators of a currency crash is simply a rapid increase in the Real Exchange Rates over 5 or 10 years. This bodes ill for the Aussie, the Yen, and a dozen other curries.

Timing is difficult, but implied vol has picked up from very low levels - i have liked variance swaps and various bearish options strategies on Emerging Market currencies since past summer, so early - should the this vol continue to rise, it could be signaling trouble is amiss.

"Carry Trades and Currency Crashes"

We conjecture that sudden exchange rate moves unrelated to news can be due to the unwinding of carry trades when speculators near funding constraints. This idea is consistent with our findings that

(i) investment currencies are subject to crash risk, that is, positive interest rate differentials are associated with negative conditional skewness of exchange rate movements;

(ii) the carry, that is, interest rate differential, is associated with positive speculator net positions in investment currencies;

(iii) speculators’ positions increase crash risk;

(iv) carry trade losses increase the price of crash risk but lower speculator positions and the probability of a crash;

(v) an increase in global risk or risk aversion as measured by the VIX equity‐option implied volatility index coincides with reductions in speculator carry positions (unwind) and carry trade losses;

(vi) a higher level of VIX predicts higher returns for investment currencies and lower returns for funding currencies, and controlling for VIX reduces the predictive coefficient for interest rate differentials, thus helping resolve the UIP puzzle;

(vii) currencies with similar levels of interest rate comove with each other, controlling for other effects.

(viii) More generally, the crash risk we document in this paper may discourage speculators from taking on large enough positions to enforce UIP. Crash risk may thus help explain the empirically well‐documented violation of the UIP.