The carry trade has been one of the most popular investment strategies over the past year, but there is concern about the potential systemic risks posed by a mass unwinding of these positions. However, some analysts suggest the dangers might not be as great as many suppose. By Mark Pengelly The carry trade stubbornly refuses to give up the spotlight. Since March, when an appreciating yen sparked fears of a rapid unwinding of carry trade positions and a systemic rout, it has rarely been far from commentators' lips.The carry trade is "so simple anyone can understand it", says one London-based banker, which may itself be a reason why it has commanded so much recent attention. The strategy involves borrowing in the currency of a country with low interest rates and investing in higher-yielding currencies. Investors profit from the interest rate differential between the two, so long as neither interest rates nor exchange rates move to a sufficient extent to scupper the trade.Current interest rates in some countries lend themselves to the perpetuation of this strategy. The Australian and New Zealand dollars look particularly attractive as target currencies, with interest rates set at 6.25% and 8% respectively. Meanwhile, the yen is one of the most popular funding currencies, given Japan's super-low interest rate of 0.5%.One side effect of the strategy is a weakening of the funding currency and a strengthening of the target currency. This is something known only too well to the Reserve Bank of New Zealand, which stepped in to stabilise the New Zealand dollar numerous times throughout June and July after continued bouts of strengthening. The New Zealand dollar hit a 22-year high of NZ$1.31 to the US dollar on June 8 after the Reserve Bank of New Zealand raised the country's interest rate by 0.25% to 8% a day earlier. By July 26, it traded at NZ$1.26 to the US dollar.Meanwhile, the yen has remained weak, consistently falling against the dollar since March. By June 22, it had fallen to its lowest level this year, at Yen123.94 to the dollar. It traded at Yen119.07 to the dollar on July 26.Most of the attention on the carry trade has centred upon hedge funds, and the short-term nature of these investors has stoked fears of a mass unwinding. As they may be heavily invested in other, potentially illiquid instruments - for instance, collateralised debt obligations referencing US subprime mortgages - volatility across financial markets could cause them to unwind carry trade positions to cover margin calls. This, so the argument goes, might lead to a quick appreciation in the yen, eroding the profitability of outstanding carry trade positions and causing greater numbers of investors to unwind positions - in turn, causing a further surge in the yen.These fears of a sharp unwind were raised at the end of February following a plunge in the Shanghai Stock Exchange composite index and a rise in US subprime mortgage delinquencies. The yen subsequently hit Yen115.15 against the dollar on March 5, a 4.7% rise from its level on February 26, and its highest level since December 2006. There were concerns again in July, after the yen hit a month-long high of Yen122.02 to the dollar on July 11, after New York-based rating agency Moody's Investors Service announced on July 10 that it would review the ratings of bonds backed by US subprime mortgages.This kind of move - along with the perceived ubiquity of the carry trade among hedge funds - has attracted attention from even the most august observers at the International Monetary Fund. It has also left foreign exchange traders eyeing general volatility closely. "We keep watching the equity and credit markets," says Mark Barnes, head of currency options at Royal Bank of Scotland Global Banking & Markets (RBS GBM) in London. "The equity markets are holding up pretty well, but the credit markets are cause for concern from a liquidity point of view."The Basel-based Bank for International Settlements (BIS) reaffirmed the role of carry trades as a driver of global exchange rates in its annual report in June, citing the yen as a major funding currency for the strategy. It also recapitulated popular market fears by alluding to the wake of the Russian financial crisis and the collapse of hedge fund Long-Term Capital Management nine years ago. Back then, the yen rose by 13.23%, from Yen134.35 to Yen116.57, over a period of four trading days, exacerbated by a quick pullout from yen-funded positions. "The investors involved are often highly leveraged," the BIS report states. "The sudden collapse of the dollar against the yen in October 1998 suggests that even large market segments can be affected by a sudden unwinding of carry trade positions."The BIS report says a steady build-up of carry trades has taken place during the year to March 2007. Despite its cautions, it adds that the trade has been profitable for most investors on a risk-adjusted basis - at least during times of exchange rate stability. Estimating the size of the carry trade is notoriously difficult, the report admits. But it draws upon speculative positions on the Chicago Mercantile Exchange (CME), foreign exchange market turnover and a regression analysis of hedge fund returns to support its thesis.In fact, speculative short yen positions on the CME, which dropped off following jitters at the beginning of March, have now picked up again. Figures published by the US Commodity Futures Trading Commission (CFTC) on July 3 show a 110% increase in speculative short yen contracts outstanding since March 6, to 198,384. This is just shy of February's peak of almost 211,000 contracts.While the CFTC figures are by no means an exact guide to how many short-term investors are involved in the carry trade, they can be seen as a rough indicator of how the trade has fared. And the data suggests hedge funds are continuing to short the yen. "Most of the speculative community has been actively selling yen to finance their acquisitions. It's clearly a trade that's absolutely overcrowded," says Cyril Beriot, London-based head of institutional forex sales at Societe Generale Corporate and Investment Banking (SG CIB).Even so, a report released by New York-based risk consulting and software firm RiskMetrics Group in June questions the extent to which hedge funds are reliant on yen-funded carry trades. Although many hedge funds may be pursuing carry trade strategies, Christopher Finger, the Geneva-based head of research who wrote the report, says fewer managers than is thought may be shorting the yen. "You're not in a situation where the entire hedge fund universe is dependent on this trade and are all likely to run for the exits. Rather, it is a mixed bag," he says.Finger analysed returns on a number of hedge fund indexes maintained by Chicago-based research company Hedge Fund Research over the past few years. Their returns were compared withthose gained from a combination of standard fixed-income strategies, as well as yen-funded carry trades invested in the Brazilian real or US, Australian or Taiwanese dollars. Finger found the HFRI Market Timing Index, which tracks funds that attempt to buy or sell rising or falling assets ahead of other players, appears to have derived a significant proportion of its returns from carry trade strategies since 2002. While it was most consistently correlated to carry trades that invested in the Australian dollar, the data showed correlations to strategies that targeted the Taiwanese dollar and Brazilian real as well.However, the HFRI Fixed Income Total Index tells a different story. The returns of that index, which tracks hedge funds employing a broad range of fixed-income strategies, including those involving arbitrage, mortgage-backed securities, and convertible and high-yield bonds, showed a strong correlation to carry trade strategies until 2002. But, despite fleeting peaks of exposure to carry trades targeting the Brazilian real, the data shows significant negative correlation to three of the carry trade strategies since 2005. The only carry trade strategy that has been positively correlated to the index since 2005 was the one targeting the Australian dollar. Several other fixed-income indexes, including the HFRI Fixed Income Arbitrage and HFRI Fixed Income Diversified, show the same pattern. "Very qualitatively, the more arbitrage-like indexes seem to be the ones that have moved to where there's a negative relationship with the carry trade," says Finger.He believes these examples challenge the assumption that all hedge funds are in a similar position when it comes to yen-funded carry trades. Moreover, even for funds that continue to exploit the carry trade, the risk of a simultaneous unwinding may not be quite as problematic as many think. While much concern in the financial community has been raised regarding these short yen positions, less attention has been paid to the precise strategies yen-shorting hedge funds may be running, Finger says.To address this issue, he came up with two model carry trade strategies and stress-tested each under a number of historical periods where the yen had appreciated dramatically. One was a simple constant maturity strategy, which invested a fixed proportion of the fund's net asset value in a three-month dollar deposit funded by three-month yen borrowing. Both positions were held until maturity and the fund's net asset value was marked-to-market on a daily basis.The other was a volatility-based strategy, which used the ratio of interest rate spreads to the implied volatility of exchange rates - or carry-to-risk - to help determine its positions. In an approach more akin to that used by many hedge fund managers, this carry-to-risk ratio was used to help determine the fund's positions. When opening a position, RiskMetrics chose the maturity where this ratio was greatest and leverage was set proportional to the ratio. The average leverage of the fund was four, and each position was closed after one week.The volatility-based strategy had a higher average return overall, at 124 basis points a month versus 13bp for the constant maturity strategy, and a lower standard deviation (9% a month compared with 13%). The research also shows that during the one-week shock in October 1998, the carry-to-risk fund avoided the worst losses suffered by the constant maturity fund. While the constant maturity fund had shed 58% of its value in the upheaval, the carry-to-risk fund's losses were only 28%. "There was a reasonable amount of difference," says Finger.A change in market positioning by the carry-to-risk fund, which would have occurred during the run-up to the yen's sharp rise, would have saved it from disastrous losses, he adds. "The carry then was less and volatility was higher. So in a strategy where you were using carry-to-risk as an automated index for how leveraged your position was, you would have somewhat backed off and not suffered quite as badly. A reasonable type of strategy would have seen that," says Finger.Although the model funds do not account for liquidity constraints in the event of a yen appreciation, the exercise does make the point that hedge fund positioning might have been characterised a little too simplistically.Indeed, dealers say those concerned about a sharp unwinding of carry trade positions by hedge funds may be a little over-anxious. "The funds I speak to know what they're doing. They're experts and professionals - they've seen major asset repricing, they've seen the 1998 crisis and they've seen other crises, so a correction in the yen is something everyone is ready for if needed," says SG CIB's Beriot.He adds that activity in the foreign exchange options market indicates hedge funds are, by and large, prepared for market tumult. This view is also reflected by RBS GBM's Barnes, who affirms that many hedge funds are protected against yen appreciation."We still see hedge funds buying high strikes in yen crosses, both Asia/yen crosses and euro/yen and Australian dollar/yen. The risk reversals are fairly high at the moment in the yen, so I think people have bought a reasonable amount of protection. Certainly people are not fully exposed," he says.A number of dealers add that funds are also hedging their short yen positions with volatility. Barnes specifically mentions one- to five-year vanilla options, variance swaps and forward volatility agreements on the yen against the dollar. If volatility in the exchange rate were to pick up - most likely signalling an unwinding of carry trades - such positions would stand to benefit. "Funds have made quite a lot of money on carry and they are getting increasingly nervous. They are looking for ways to hedge themselves in case of an unwinding and seem to have decided that buying foreign exchange volatility is their asset class and protection of choice," says Barnes.John Normand, global currency, commodity and fixed-income strategist at JP Morgan in London, agrees that hedge funds' role in the yen carry trade has been a little overplayed. He remarks that a focus on hedge funds misses the real factor underpinning the yen carry trade. "What's more important is the Japanese investor," he says.JP Morgan puts the size of foreign bond investments by Japanese domestic investors at Yen30 trillion. This compares to a mere Yen2 trillion-3 trillion in positioning by foreign hedge funds, a figure that also includes Japanese forex margin traders. This phenomenon has not gone unnoticed by the country's central bank. On July 2, Kiyohiko Nishimura, a member of the Bank of Japan's policy board, gave a speech in which he claimed that Japanese households were having a sizable impact on the international financial system. From around 0.5% in 1994-96, Japanese investors' holdings of foreign currency-denominated assets had increased to 2.8% of their total investments by March 2007, he stated."Years ago, it was the gnomes of Zurich who shook the foreign exchange markets. They have now been replaced by the housewives of Tokyo," he declared. He added that these investors had helped to stabilise the yen in recent years by using periods of yen appreciation to build up greater amounts of foreign currency-denominated assets. In this sense, they may well have been acting as a cushion for foreign hedge funds dabbling in yen-funded carry trades.This more balanced outlook, however, is not without its dangers. Andrew Smithers, London-based founder of Smithers & Co and a specialist on global imbalances caused by the Japanese economy, reckons both sides of the carry trade deserve attention. "If Japanese domestic investors were to continue to invest in the same place as before and the yen carry trade were to come to a halt, that would have a significant effect. Equally, if the yen carry trade were to continue as it is and Japanese investors were to either accelerate their buying or stop, that would also have an impact."However, due to the more medium- to long-term nature of their investments, Japanese retail investors should not prove as big a worry as hedge funds, despite the scale of their involvement, says JP Morgan's Normand. "Those investors are less susceptible to a reversal over the short term," he says.So what sort of event could make Japanese investors bolt from foreign currency-denominated assets? According to those in the market, the answer has to be an increase in Japan's 0.5% interest rate, which would also have consequences for hedge funds shorting the yen. But despite the Bank of Japan's recent acknowledgement of the risks posed by current foreign exchange market dynamics, it held off raising rates at its last opportunity on July 12. "The Bank of Japan is slow in normalising rates, and as long as that remains the policy backdrop, the carry trade is fairly secure," says Normand.Neither Normand nor anyone else in the market expects Japanese interest rates to stay low forever. But while they do, and hedge funds can keep leaning on the housewives of Tokyo, the best advice to them might be: carry on....
Start a FREE trial or subscribe to continue reading:
Start a 4 week free trial
Try Risk.net's premium content for a limited period. Register now for your FREE trial to one of our leading brands.
*not available to previous trialists or subscribers.
Log In or Subscribe Now
Subscribe to Risk.net Business now to access all our premium news & features content for 1 year.
Pay by Credit Card for immediate access.