Active Currency Management Based on the Carry Trade
In 2016, currency investors were able to make a fortune by using interest rates to essentially borrow in JPY at negative rates and then invest in USD at positive rates. It was a fantastic strategy. So why would you want to borrow in JPY?
What's another way to think of this strategy?
No.
The JPY has a negative interest rate.
That's not it.
The interest rate on JPY is negative.
What should happen to USD so that uncovered interest rate parity holds?
That's it!
USD should depreciate so that the currency returns of JPY and USD are equal. That makes the yield advantage offset by the currency depreciation, and on average, equates the currency returns.
But that doesn't always happen, as many high-yielding countries' currencies will appreciate for short-to-medium terms, and that's where carry traders can take advantage through forward currency rates.
No.
USD is already paying a higher interest rate, so it won't appreciate if the returns need to balance.
No.
Rate changes won't impact the balancing of uncovered interest rate parity. Currency value changes determine that balancing.
In fact, this advantage is called the __forward rate bias__, or the tendency of the forward rate premium to overstate the amount of appreciation in the base currency and the discount to overstate the amount of depreciation.
It's actually a bias because uncovered interest rate parity states that the forward rate should be an unbiased predictor of future spot rates. But that's definitely not the case, so how would you take advantage of forward rate bias?
Why will markets price the lower-yielding currency at a premium?
No.
You want to buy low and sell high, so that's not going to help you earn money.
No.
The forward premium is typically overstated, so that's not going to earn you the return you're expecting.
No.
The forward rate premium isn't expected to widen under normal market conditions.
That's not it.
Arbitrage will happen through pricing, not rates.
In either strategy, gains are essentially risk premiums for taking certain unhedged exposure. What do gains compensate you for?
No.
These nations aren't going to default on their currency.
If you were to graph these potential losses, what would the graph look like?
Not quite.
That's a risk, but it's not the primary risk that you're receiving compensation for.
Which volatility level would you desire for a carry trade?
Yes.
You'd want lower volatility between the currency pair because that should indicate lower risk. That's why traders look toward the historical volatility level of currency pairs and also use multiple funding currencies and investment currencies.
These multiple currency exposures don't need to be balanced—there can be four funding currencies and six investment currencies, depending on the exposure you want and the weights you use.
Not quite.
Even medium volatility can lead to large losses.
No.
That's going to involve significant risk.
To sum it up:
[[summary]]
Not quite.
If the interest rates continue for some time, you'll want to earn the interest spread.
No.
You won't just buy and hold the currency pair. It's a tactical strategy that takes advantage of the market.
Not so.
Positive skew results from upside potential, not negative losses.
No.
There's the potential for large losses, so that's not a standard distribution.
That's it!
You'd want to borrow in the currency that has negative rates because you'd actually receive interest through shorting bonds. This is an example of the __carry trade__, or the trading strategy of borrowing in a low-yield currency and investing in a high-yield currency. Basically, carry trade strategies take advantage of uncovered interest rate parity violations in the market.
Indeed!
Trading the uncovered interest rate parity takes advantage of the natural opportunities in the market. That's arbitrage.
For example, uncovered interest rate parity states that an unhedged foreign currency position will be the same as the domestic-currency investment. That means that the yield spread advantage for USD will, on average, be matched by a change in USD.
Yes indeed!
You want to buy low and sell high, so if the forward rate overstates appreciation, then you'll want to sell. Similarly, if the discount understates the forward rate discount, you'll want to buy.
Essentially, traders have two ways to express currency trades that take advantage of a break in uncovered interest rate parity: the carry trade or trading the forward rate bias. They're basically the same strategy because you're taking advantage of the fact that markets will price the higher-yielding currency at a discount and the lower-yielding currency at a premium.
Exactly!
Uncovered interest rate parity indicates that the lower yield currency should appreciate or that the higher-yielding currency should depreciate so that the returns equate. That's the natural pricing structure, and it gives traders opportunities to earn returns by buying the higher-yielding currency (carry trade) or the forward rate discount (forward rate bias). Or traders can sell the low-yield currency (carry trade) or the forward premium currency (forward rate bias).
Yes.
You're taking unhedged currency risk, which is why these strategies can earn positive returns. But that currency risk isn't just a straight normal distribution because carry trades involve leverage through borrowing at the lower-yielding currency rates. You'll need to be careful, because in difficult market environments, carry trades can turn quickly and result in losses.
That's right!
Potential losses will lead to significant negative skew. This results from the fact that most times the __funding currency__, or the currency that's borrowed, is a safe-haven currency like USD, JPY, or CHF in a country that's stable. But the __investment currency__, or the higher-yielding currency, is usually from countries with higher risk. So when the market environment turns, carry traders can get caught in losing positions that have magnified losses due to leverage. That's why carry traders analyze the historical volatility between the currency pair.
It has a higher-interest cost
It has a lower borrowing cost
It has a higher-interest return
Arbitrage
Day trading
Buy-and-hold
It should depreciate
It should appreciate
Rates should decrease
Sell the currency at the forward premium
Sell the currency at the forward discount
Buy the currency at the current spot to earn the forward premium
Arbitrage should make the premium widen
Arbitrage should make interest rates increase
Arbitrage should make the currency appreciate
Default risk
Currency risk
Interest rate risk
Positive skew
Normal distribution
Significant negative skew
Low volatility
Medium volatility
Extremely high volatility
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