Reinforcing my knowledge on carry-trade: 1) Borrow in a currency that has a compartively low interest rate (eg. U.S. right now). 2) Receive the money, proceed to sell the currency for another that yields a higher interest rate (oh I dont know…maybe the Euro). 3) Invest the money in the higher interest rate with the same duration as the liability. 4) Hedge the currencies to prevent any negative fluctuations affecting the gains. One thing that I do not understand here: when a currency has low interest rates, wouldn’t it drive investors’ interest away -> further downward pressure on the currency? Theortically speaking…is there even a need to hedge the currencies?
Welcome to level 2, my friend!
Just refreshing the knowledge my friend.
That’s generally correct. The key is to successfully hedge the currency risk. Another way to do it is if you think that country 1 is going to keep lowering interest rates. People were doing this with JPY for some time in the past.
I’m not sure about the hedging part. In theory, you can hedge using forwards, futures, or swaps, but the forward/future price is going to be based largely on interest rate differentials through covered interest arbitrage (plus a supply/demand determined bid/ask spread), so you’d need some reason to think that the forward/future prices are out of line over and above simple transaction costs. I could be wrong here, but I’d think if you had some reason to think that, you’d probably want to have some exposure anyway, in which case you wouldn’t hedge. In practice, carry trades are not always done using sovereign debts. Some people just borrow dollars and invest in something like Russian equities. Obviously, it’s not an arbitrage, because the risk characteristics of dollars and Russian equities are hard to match against each other precisely. That’s what some macro guys do, though it’s not a strategy discussed much in the CFA curriculum, unless it’s disguised as a swap problem (the kind you really hope doesn’t show up on the exam).
Actually, a popular currency carry strategy is to try to take advantage of interest rate differentials when, for whatever reason, you expect the exchange rate between two currencies to remain relatively constant throughout your trade. So you’re right in a sense that 1) you have to believe that the rates differential doesn’t reflect future appreciation or depreciation of one of the currencies, and 2) you can keep unhedged FX exposure - the problem is you might lose money if the exchange rate does move significantly. However, if 1) is not true, then you could try to hedge your FX exposure somehow while retaining some of the carry from the rates differential. This is usually difficult to do in practice, since FX futures tend to reflect the rates differentials - if you hedge with futures, you lose the carry. So, you need to be creative and find some other security that is correlated with FX exchange rates.
Interesting article by Roubini on the topic: Since March there has been a massive rally in all sorts of risky assets – equities, oil, energy and commodity prices – a narrowing of high-yield and high-grade credit spreads, and an even bigger rally in emerging market asset classes (their stocks, bonds and currencies). At the same time, the dollar has weakened sharply, while government bond yields have gently increased but stayed low and stable. This recovery in risky assets is in part driven by better economic fundamentals. We avoided a near depression and financial sector meltdown with a massive monetary, fiscal stimulus and bank bail-outs. Whether the recovery is V-shaped, as consensus believes, or U-shaped and anaemic as I have argued, asset prices should be moving gradually higher. But while the US and global economy have begun a modest recovery, asset prices have gone through the roof since March in a major and synchronised rally. While asset prices were falling sharply in 2008, when the dollar was rallying, they have recovered sharply since March while the dollar is tanking. Risky asset prices have risen too much, too soon and too fast compared with macroeconomic fundamentals. So what is behind this massive rally? Certainly it has been helped by a wave of liquidity from near-zero interest rates and quantitative easing. But a more important factor fuelling this asset bubble is the weakness of the US dollar, driven by the mother of all carry trades. The US dollar has become the major funding currency of carry trades as the Fed has kept interest rates on hold and is expected to do so for a long time. Investors who are shorting the US dollar to buy on a highly leveraged basis higher-yielding assets and other global assets are not just borrowing at zero interest rates in dollar terms; they are borrowing at very negative interest rates – as low as negative 10 or 20 per cent annualised – as the fall in the US dollar leads to massive capital gains on short dollar positions. Let us sum up: traders are borrowing at negative 20 per cent rates to invest on a highly leveraged basis on a mass of risky global assets that are rising in price due to excess liquidity and a massive carry trade. Every investor who plays this risky game looks like a genius – even if they are just riding a huge bubble financed by a large negative cost of borrowing – as the total returns have been in the 50-70 per cent range since March. People’s sense of the value at risk (VAR) of their aggregate portfolios ought, instead, to have been increasing due to a rising correlation of the risks between different asset classes, all of which are driven by this common monetary policy and the carry trade. In effect, it has become one big common trade – you short the dollar to buy any global risky assets. Yet, at the same time, the perceived riskiness of individual asset classes is declining as volatility is diminished due to the Fed’s policy of buying everything in sight – witness its proposed $1,800bn (£1,000bn, €1,200bn) purchase of Treasuries, mortgage- backed securities (bonds guaranteed by a government-sponsored enterprise such as Fannie Mae) and agency debt. By effectively reducing the volatility of individual asset classes, making them behave the same way, there is now little diversification across markets – the VAR again looks low. So the combined effect of the Fed policy of a zero Fed funds rate, quantitative easing and massive purchase of long-term debt instruments is seemingly making the world safe – for now – for the mother of all carry trades and mother of all highly leveraged global asset bubbles. While this policy feeds the global asset bubble it is also feeding a new US asset bubble. Easy money, quantitative easing, credit easing and massive inflows of capital into the US via an accumulation of forex reserves by foreign central banks makes US fiscal deficits easier to fund and feeds the US equity and credit bubble. Finally, a weak dollar is good for US equities as it may lead to higher growth and makes the foreign currency profits of US corporations abroad greater in dollar terms. The reckless US policy that is feeding these carry trades is forcing other countries to follow its easy monetary policy. Near-zero policy rates and quantitative easing were already in place in the UK, eurozone, Japan, Sweden and other advanced economies, but the dollar weakness is making this global monetary easing worse. Central banks in Asia and Latin America are worried about dollar weakness and are aggressively intervening to stop excessive currency appreciation. This is keeping short-term rates lower than is desirable. Central banks may also be forced to lower interest rates through domestic open market operations. Some central banks, concerned about the hot money driving up their currencies, as in Brazil, are imposing controls on capital inflows. Either way, the carry trade bubble will get worse: if there is no forex intervention and foreign currencies appreciate, the negative borrowing cost of the carry trade becomes more negative. If intervention or open market operations control currency appreciation, the ensuing domestic monetary easing feeds an asset bubble in these economies. So the perfectly correlated bubble across all global asset classes gets bigger by the day. But one day this bubble will burst, leading to the biggest co-ordinated asset bust ever: if factors lead the dollar to reverse and suddenly appreciate – as was seen in previous reversals, such as the yen-funded carry trade – the leveraged carry trade will have to be suddenly closed as investors cover their dollar shorts. A stampede will occur as closing long leveraged risky asset positions across all asset classes funded by dollar shorts triggers a co-ordinated collapse of all those risky assets – equities, commodities, emerging market asset classes and credit instruments. Why will these carry trades unravel? First, the dollar cannot fall to zero and at some point it will stabilise; when that happens the cost of borrowing in dollars will suddenly become zero, rather than highly negative, and the riskiness of a reversal of dollar movements would induce many to cover their shorts. Second, the Fed cannot suppress volatility forever – its $1,800bn purchase plan will be over by next spring. Third, if US growth surprises on the upside in the third and fourth quarters, markets may start to expect a Fed tightening to come sooner, not later. Fourth, there could be a flight from risk prompted by fear of a double dip recession or geopolitical risks, such as a military confrontation between the US/Israel and Iran. As in 2008, when such a rise in risk aversion was associated with a sharp appreciation of the dollar, as investors sought the safety of US Treasuries, this renewed risk aversion would trigger a dollar rally at a time when huge short dollar positions will have to be closed. This unraveling may not occur for a while, as easy money and excessive global liquidity can push asset prices higher for a while. But the longer and bigger the carry trades and the larger the asset bubble, the bigger will be the ensuing asset bubble crash. The Fed and other policymakers seem unaware of the monster bubble they are creating. The longer they remain blind, the harder the markets will fall.