Subprime crisis forces carry trade unwinds

Recent turmoil in the credit markets caused by US subprime mortgage woes has spread to the foreign exchange market, with abrupt adjustments in the values of currencies indicating that some investors have been unwinding carry trade positions over the past few months.

The carry trade involves borrowing in the currency of a country with low interest rates (for instance, Japan) and investing in higher-yielding currencies (such as Australia or New Zealand). 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 erode this differential. An unwinding of this strategy would, all things being equal, result in a strengthening of the borrowing currency and a weakening of the target currency.

The yen hit ¥112.14 against the dollar on August 16, the highest level since June 2006, and was trading at ¥115.72 on August 31. It had been trading at ¥119.74 on August 8 and ¥123.94 on July 22. The Australian dollar, meanwhile, weakened to $0.7838 cents on August 16, compared with $0.8615 on August 8. The Australian dollar/yen cross-rate also exhibited significant volatility: the yen strengthened to ¥89.42 against the dollar on August 18, having traded at ¥106.96 on July 24. It closed at ¥94.59 on August 31.

The largest moves coincide with a 50 basis point cut in the US Federal Reserve’s discount rate to 5.75% on August 17. However, analysts say there was significant unwinding of carry trade positions in August.

“The types of investors I have seen unwinding their carry trade positions are retail investors, some non-leveraged market funds and hedge funds,” said Geoffrey Yu, a foreign exchange strategist at UBS in London. He added that hedge funds are unwinding carry trade positions to meet margin calls following losses in their credit portfolios.

This unwinding has affected some structured products that employ carry trade strategies. Dresdner Kleinwort, for example, has reported a decrease in value for some of its Dresdner Interest Rate Differential Arbitrage (Dida) indexes over the past month.

“July has seen reductions in the value of some of our indexes, but we are not too concerned because there has been overall good performances for them since the beginning of the year,” said Martin Hartmann, London-based head of structuring equity credit derivatives at the German bank.

In July, the Dida G-5 Index (a carry trade index that focuses on euro, Swiss franc, sterling, dollar and yen) lost the gains that it made in June, but the index is still up 25% since January. The Dida G-5 Index has a monthly investment horizon, and Hartmann says the decision was taken on August 1 to close the index’s yen short positions.

The Dida Asian index, meanwhile, was down 7% over July, but is still up 86% since the beginning of the year. The decrease was partly attributed to a weakening of the New Zealand dollar, and the index has subsequently closed its positions on this currency, says Hartmann. The Dida Latin American index was down 9% in July, but is up 28% since January, while the Dida Turkey index was not affected much by currency changes. It was up 6% in July and up 67% since January.

Dresdner Kleinwort has sold capital protection notes and swaps linked to the Dida indexes. The bank reports that these structured products have lost a maximum of 4% of their value since the beginning of July, although this comes after significant positive performances in the first half of the year. Dresdner Kleinwort declined to give further details.

“Investors that have invested in our indexes know that volatility is part of the currency market and so have held their investment in our indexes. Potential investors are observing what is happening in the market and may be holding back, but that is not just with regards to our products,” says Hartmann.