Carrying on

The recent rapid appreciation of the yen is the scenario regulators dreaded, setting the scene for huge hedge fund losses and a mass unwinding of carry trades. The reality has been somewhat different. By Ryan Davidson

Currency traders have endured a hair-raising few months. After weathering much of the volatility in the financial markets in the third and fourth quarters of last year, the foreign exchange markets have been making up for lost time. Having touched 12-year lows against the yen in March, the dollar hit its lowest-ever level against the euro on April 24 (0.62690 dollars/euro).

The yen's sharp appreciation, in particular, represents something of a nightmare scenario for some. Regulators have long warned about the steady build-up of carry-trade positions by hedge funds - most of which are funded by yen borrowing. A rapid strengthening of the yen, so the theory goes, would cause huge mark-to-market losses for investors with outstanding carry-trade exposures, forcing more to unwind trades; in turn, causing a further spike in the yen and more losses for those hanging grimly on to open positions. In the worst-case scenario, a mass unwinding of carry trades could pose a major systemic risk to the financial markets, some regulators argue.

Rapid rise

Certainly, the yen's ascent was rapid, breaching Yen100 to the dollar on March 13 and touching Yen95.76 in intra-day trading on March 17 (see figure). The currency had started the year at Yen111.79, and had traded at Yen123.94 as recently as June 22, 2007. Nonetheless, the rout many had feared has not materialised.

Yet the past few months have not been pretty for hedge funds. Only three of the 13 strategies in the Credit Suisse/Tremont hedge fund index reported positive returns in March - dedicated short bias, equity market-neutral and risk arbitrage - although there has been an improvement since, with three posting negative returns in April. Eight strategies are down since the start of 2008, with the worst performer being convertible arbitrage, which was down 6.62% as of the end of April. Nonetheless, dealers say many hedge funds had already unwound or hedged carry-trade positions, enabling them to weather the worst of the currency moves.

The carry trade involves borrowing in the currency of a country with low interest rates and investing in higher-yielding currencies. Investors are able to make money from the interest rate differential between the two, so long as neither interest rates nor exchange rates move to a sufficient extent to erode the profitability of the trade.

In its most recent annual report, published in June 2007, the Bank for International Settlements identified the yen as a major funding currency for carry-trade strategies, due to the country's low interest rate of 0.5%. The report says a steady build-up of carry-trade positions had taken place in the year to March 2007 and the unwinding of these trades could contribute to market instability and have a large impact on exchange rates, particularly in smaller markets.

Carry trade unwinding has been held at least partly responsible for periodic bouts of yen strengthening in May and June 2006, February 2007 and August 2007. For instance, the currency appreciated from Yen121.02 on February 22, 2007 to Yen116.01 on March 5, and jumped from Yen119.74 to Yen112.14 between August 8 and 16.

In both cases, the strengthening followed a shock in the financial markets - in the first instance, a plunge in the Shanghai Stock Exchange composite index and a rise in US subprime mortgage delinquencies; and in the second case, the stepping up of the subprime crisis following the collapse of two Bear Stearns hedge funds, the bail-out of Dusseldorf-based IKB Deutsche Industriebank and the suspension of redemptions on three BNP Paribas funds. This prompted speculation that hedge funds, facing margin calls on loss-making structured credit positions or spooked by increased volatility, had unwound carry trade positions.

Nonetheless, analysts say there are macroeconomic reasons for the most recent surge in the Japanese currency - not least seven rate cuts by the US Federal Reserve since September. The most recent cut, on April 30, reduced the federal funds rate by 25bp to 2%.

Certainly, those hedge funds with open yen-funded carry-trade positions would be likely to be nursing heavy mark-to-market losses. However, dealers say many hedge funds have switched to long yen positions over the course of the past year. Speculative short yen positions on the Chicago Mercantile Exchange - often seen as an indicator of outstanding carry-trade positions - have drastically shrunk over the past 12 months. On April 24, 2007, there were 120,100 short yen contracts outstanding, versus just 32,068 long positions, according to figures from the Commodity Futures Trading Commission. As of April 22 this year, that had fallen to 25,364 short contracts, while long positions had increased to 57,288 contracts.

Christopher Finger, Geneva-based head of research at New York-based risk consulting and software firm RiskMetrics Group, says there is now little relationship between the unwinding of carry trades by hedge funds and dollar/yen movement. "In the first half of last year, the statistical relationship was at best moderate," he says. "Since then, I would speculate they have been unwinding positions on popular carry trades, such as dollar/yen, partly to meet margin calls and partly in anticipation of dollar weakening."

RiskMetrics conducted research last year that questioned the extent to which hedge funds are reliant on yen-funded carry trades. The research found that some hedge fund strategies had a negative correlation to the carry trade, suggesting hedge fund managers were not as reliant on the carry trade as some observers had feared.

The research also described two carry-trade strategies - a simple constant-maturity strategy and a volatility-based strategy. The latter uses the ratio of interest rate spreads to the implied volatility of exchange rates to determine positions, an approach similar to that used by most hedge funds. As such, an increase in volatility would be likely to prompt users of this strategy to reduce leverage. In other words, hedge funds may well have reduced their exposures ahead of the spike in the yen over the past few months.

Volatility plays

Three-month yen implied volatility was at around 8% or less for most of the first half of 2007, but has averaged above 10% in 2008. "The yen has traditionally been a popular funding currency, but recently people are buying it back - and that has been a major factor for the currency's volatility," says Chris Leuschke, head of currency structuring at the Royal Bank of Scotland in London. "In the past six months, the volatility of exchange rates has increased, making attractive risk-versus-return carry trades harder to find."

While some funds would have closed out trades, others have used currency options to hedge short yen exposures. Variance swaps have also increasingly been utilised as a hedge on carry-trade positions. These instruments have a payout equal to the difference between the realised variance and a pre-agreed strike level, multiplied by the notional value. The idea is that an unwinding of carry trades would probably lead to a rise in yen volatility - meaning those investors with long-variance positions would profit, offsetting any losses on outstanding carry trade exposures.

In fact, variance swaps are increasingly being used as cheap portfolio insurance by hedge funds not usually active in the forex markets. For those investors with foreign currency-denominated equities, for instance, a market shock and mass sell-off would have a knock-on effect on both exchange rates and currency volatility. By using variance swaps on foreign exchange rather than equity variance swaps or index puts, hedge funds can achieve substantial savings on their portfolio insurance, say dealers.

"In the past year, we've seen an increasing number of non-forex hedge funds start using forex derivatives to hedge their portfolio positions" says Chris Hansen, head of forex investor sales for Europe at Deutsche Bank in London. "This is particularly true of assets affected by dollar and sterling price movements. These funds now see forex as more of an opportunity, not a risk. Even before July last year, but especially since, we have seen an increase in the use of forex variance swaps by hedge funds, exploiting relationships between equity and forex volatility."

But it's not all about hedging. The increase in currency volatility has also created plenty of trading opportunities - a fact several hedge funds have latched on to. "Having static, non-trending exchange rates is the worst scenario for our trading strategy, as it makes money on the rise and fall of the rates," says Chris Cruden, chief executive of Switzerland-based investment manager Insch Capital Management.

The firm's Kintillo fund is based on a quantitative analysis of the currency markets, with buy and sell signals generated by price movements and volatility. The fund trades 10 cross-rates, including dollar/euro, dollar/yen and euro/yen.

"We don't build positions - we open and close diversified, risk-equivalent trades with a short to medium investment horizon, which can last from a few days to a couple of months," says Cruden.

Likewise, Zurich-based hedge fund Olsen Invest uses an algorithm to trade on a short-term basis. Chief executive Richard Olsen says he welcomes the recent volatility in the currency markets. "We trade on many small currency movements rather than aiming to profit on larger, long-term views," he says. "We made a profit through the volatile period in March and don't see the ongoing volatility as a threat to our business."