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The Carry Trade and Volatility

In our ETF based newsletter, the carry trade is one of the strategies that we employ. For those unfamiliar with the carry trade, you are essentially trading the interest rate differentials of different countries. You short a low-yielding currency and go long a higher-yielding currency.

You can make money in two ways. You earn the “carry” if the currencies remain very stable, and neither move. You can also make money in this trade by being correct in the direction. For instance if you are short the Japanese Yen and long the Australian dollar, then you can also make money if the Australian dollar goes up, and the Yen goes down.

As an example of how to earn the carry, lets look at the Japanese Yen versus the Australian Dollar. The Yen has been the carry trade vehicle of choice for much of the past decade because Japan has consistently had extremely low interest rates. Australia, on the other hand, has had relatively high rates over the last decade.

To construct the differential for this trade, take one rate and subtract the other rate. In the chart below, we plot the difference between the AUD and the Yen since the beginning of 2007. As you can see, at one point the carry was as high as 7.34, but it has since declined to 2.69. If you had been long the AUD and short the Yen, you would have earned this interest rate differential the whole time.

AUD-JPY Interest Rate Differential

AUD-JPY Interest Rate Differential

Of course as we already mentioned, in order to make money on the carry trade, your long must outperform or stay flat relative to your short position in order to make money since a big directional move against you will wipe away any gains that you would be making solely off the carry.

There have been several academic studies as well as real world trading results that show that volatility is the biggest risk that the carry trade faces. Over the years, most studies were stuck using the SP500 VIX as a proxy for global financial market volatility. While it correlates quite well, there are now some far better options to help track and manage risk in the currency markets. We at The Macro Trader use the JP Morgan G-7 VIX index for our carry trading model as it correlates extremely well to the volatility in the DBV-Currency Harvest Trust ETF.

What we first found in the academic literature, later confirmed by our own testing and used successfully in our trading, was that when volatility in the currency markets is flat or declining, the carry trade works very well. On the other hand, when currency volatility is high, the carry trade typically is a money loser because the directional aspect of the trade overwhelms the carry, giving you a loss.

We look at the JP Morgan G-7 VIX using two different charts. The first one is a reversion to the mean chart where plot the VIX data, the historic mean, then one and two standard deviations above and below the mean. When volatility is high and then falls below one standard deviation, we start looking to enter the carry trade and when it get above the one standard deviation line we would sell if not already stopped out. On the downside, we look to sell when volatility declines too much since it represents excessive complacency and usually is a sign of higher volatility ahead.

JP Morgan G-7 VIX

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The other way that we like to look at the currency VIX is to invert it on a chart alongside the DBV. As you can see in the below chart, not only was equity volatility declining, but DBV managed to base for a few months before climbing higher and then consolidating at its 200-day moving average. Finally today it was able to break out to the upside.

DBV and JPM G-7 VIX

dbv-vxy

Finally we have the DBV itself. As you can see in the chart below, not only was equity volatility declining, but DBV managed to base for a few months before climbing higher and then consolidating at its 200-day moving average. Finally today it broke out to the upside.

DBV-Carry Trade ETF

dbv

Hopefully you see how volatility is bad for a lazy trade like the carry trade where you trying to get paid for sitting. If volatility climbs above 1 standard deviation above its mean we will look to tighten our stops as the odds of a downside move increase significantly.

DBV-G-10 Currency Harvest Fund is an ETF that goes long the three highest yielding currencies of the G-10 and shorts the three lowest yielding currencies on a 2x levered basis. While investors can go into the spot and futures FX markets and put on the same trade the DBV is a very simple way to gain exposure to positive carry in the currency markets.

Happy Trading,

Dave@TheMacroTrader.com

http://TheMacroTrader.com

Disclaimer-We currently hold positions in the DBV-G10 Currency Harvest Fund and FXA-Australian Dollar ETF.

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and mentioning The Macro Trader to friends and co-workers. Here’s the link information for this article:
Title: The Carry Trade And Volatility
URL: http://www.themacrotrader.com/2009/06/01/the-carry-trade-and-volatility/

Volatility and the Carry Trade

The classic version of the carry trade in the currency markets involves going long the three highest yielding currencies and going short the three lowest yielding currencies in the G10 nations.  The same principle can be applied to any two currencies.  Simply go long the higher yielding against the lower yielding.  When you do this you will earn the interest rate differential.  If X nations short term rates are at 8% and Y nations rates are 2% then you can make 6% on the “carry” on the interest rate differential.  When you apply a bit of leverage you can earn quite a bit more.

As with any trade there are risks involved with the carry trade. One of the greatest risks to the carry trade is volatility.  When volatility rises the return from the carry trade declines. In the chart below we have a chart of the DBV which is an ETF that goes long the three highest yielding currencies from the G10 nations and short the three lowest yielding currencies as well as the JP Morgan G7 VIX (we inverted the G7 VIX).  It is obvious that as volatility increases the returns from the carry trade decline.

JP Morgan Carry Trade VIX DBV ETF

One idea that we shared with subscribers in our latest issue was to go long the DBV in anticipation of a decrease in volatility. As you can see in the chart volatility has been declining the last few weeks. Based on this and other factors we like this as a short term trade.

Happy Trading,
The Macro Trader

P.S. If you would like to receive our new FREE course “Macro Trading 101” put your e-mail in the box below.

Active Beta and the Carry Trade

Previously we have written about our active-beta strategies and how we are applying them to equities and fixed income. We also mentioned how we were working on a solution to systematically take advantage of the carry trade. After a lot of research we have finally devised an acceptable method to capture returns while at the same time minimizing drawdowns.

In the initial stages of research we did a lot of search and came across a few good and several bad ideas. One of the most insightful things we read came from Macro Man . He wrote where he uses a volatility filter to tell him when it is a good time to be involved in the G-10 carry trade. After further research we found it to be true that the best time for the carry trade is when things are fairly stable and volatility is low or declining and the worst time is when it is high or rising. This of course makes sense since the majority of this strategy revolves around trying to

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capture interest rate differentials from high yielding currencies versus the low yielding currencies. When excessive volatility comes into the market many participants will start to unwind their leveraged positions and in so doing they can wipe out a lot of gains from the carry. Using a volatility filter helps to sort out the high, moderate, and low risk times. For the most part we want to be involved in the moderate and low risk times and step aside in the high risk times.

Of course volatility is not the only risk to the carry trade. Anytime a central bank decides to change rates the carry will change and depending on what they do you can make or lose money. Also if a few large market participants quickly unwind positions you can get hit before the filter is triggered. What we have attempted to do is to simply eliminate a regularly occurring risk and improve our risk-adjusted returns by avoiding that risk.

Some investors new to currency trading might be wondering what is the carry trade? It is when you go long a high yielding currency and go short a low yielding currency. The G-10 carry trade is simply to go long the three highest yielders and go short the three lowest yielding

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currencies. Right now for instance you would be long the New Zealand Loonie, Australian Dollar, and the Norwegian Krone. You would go long these against the Japanese Yen, US Dollar, and Canadian Dollar. In a currency account you can put these on and then decide how much leverage you want to use. If you are new to currency trading and/or are constrained in your trading instruments you can just buy the DBV-Deutsche Bank G10 Currency Harvest ETF. It does exactly this strategy and applies 2X leverage. Since TheMacroTrader.com trades ETF’s we use the DBV to take advantage of the carry trade.

Happy Trading,

The Macro Trader

P.S. If you would like to receive our new FREE course “Macro Trading 101” put your e-mail in the box below.

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