Carry Trade Interest Rebounds On Speculation Of Lehman Brothers Buyout

The DailyFX Carry Trade Index marked a sharp rebound (evident in many of the yen crosses) through Friday’s close, but not before dropping to its lowest level since July 11th, 2006. This is a situation were strength is based on precarious elements at best. A genuine recovery in risk appetite will require a tangible improvement in the outlook for the financial sector and economic activity.

• Carry Trade Interest Rebounds On Speculation Of Lehman Brothers Buyout
• With Risk Still Very High And Returns Fading, Can A Rebound Be Sustained?
• Where Do Expectations Of A Cooling Global Economy Fit Into The Carry Rebound?

The DailyFX Carry Trade Index marked a sharp rebound (evident in many of the yen crosses) through Friday’s close, but not before dropping to its lowest level since July 11th, 2006. This is a situation were strength is based on precarious elements at best. A genuine recovery in risk appetite will require a tangible improvement in the outlook for the financial sector and economic activity. By the close of the week, the Carry Trade Index stood at 26,534 for an actual improvement over last Friday’s close of 165 points. However, a more objective look at carry cuts optimism short. The entire improvement through the past week was based on a late 540-point rebound from the new two-year low. What’s more, market condition indicators have done little to bolster expectations of a true trend change. Risk reversals are still trending in favor of bearish puts; but more worrisome is the level of volatility in the currency market. The DailyFX Volatility Index is well above 11 percent and pushing highs not seen since regulators were sorting out the Bear Stearns mess.

The fundamentals underlying the popular yield strategy look a lot like the technicals of the index. With risk appetite drudging new lows and the outlook for returns shrinking, the market was primed for any sign of improvement. The spark for a rebound came from news and speculation of bailouts. After a plan was drafted over the weekend, the Treasury Department took the helm for the quickly sinking Freddie Mac and Fannie Mae. However, even though this rescue secured over $5 trillion in debt; the market was clearly focused on other problems. Instead, the much more precarious health of Lehman Brothers was starting to resemble the collapse of Bear Stearns (Fannie and Freddie were already relatively secure as government sponsored enterprises). Going into the end of the week, the fate of the number three securities firm was still up in the air with rumors emerging that a consortium was interested but that the government would not facilitate a purchase. If Lehman is bought, it would likely give short-term momentum to the carry rebound. However, looking beyond this averted financial crisis, there is a long list of banks on the Fed watch list and global growth is cooling. What’s more, with the RBA and RBNZ cutting rates (the latter by 50 bps this week), the reward for taking such risky exposure may not balance anymore.

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Risk Indicators:

Definitions:

DailyFX Volatility Index

What is the DailyFX Volatility Index:

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.

USDJPY 25 Delta Risk Reversals 3 Month

What are Risk Reversals:

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  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.

Bank of Japan Rate Expectations

How are Rate Expectations calculated:

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.

Written by: John Kicklighter, Currency Strategist for DailyFX.com
Questions? Comments? Send them to John at jkicklighter@dailyfx.com.