Carry Over Trade Boom or a Bust ?
Msc Mathematical Trading and Finance
Project Semester B
By
AMIT PATEL
Student No. 070026966
CASS BUSINESS SCHOOL
SMM522
PROJECT ASSESSMENT TRANSCRIPT
Student Name:
Session:
Amit Patel
Student Number: 070026966
Project Title:
CARRY OVER TRADE BOOM OR A BUST ?
Project Tutor: Professor John Hatgioannides
Semester Start: B
Course: MSC MTF
AKNOWLEDGEMENT
This study would not have been possible without the support and assistance of a number
of people and organizations as well as my family. Mr Babulal Patel, father to me, was the
source of the inspiration and incentive to begin the research effort. He provided critical
assistance along the way. His help was invaluable as he is a FX trader and conducts
research in FX and Commodity market since 15 years.
Members of my staff assisted with this study in myriad ways. Especially I am grateful to
Professor John Hatgioannides who allowed me to do this project and who was all the way
helpful towards my successful completion of project.
No study of this size can be completed without disruption of one’s normal family and
work routine. This project could not have been completed without the support,
encouragement, and love and caring of my family and work mates due to their
exceptional support.
The Precious knowledge attributes of this report are derived from those mentioned above,
from my 4 years of trading experience and many other internet sources. The conclusions
and any errors, omissions or mistakes within this report are attributable only to the author.
Best regards,
Amit Patel
Cass Business School
TABLE OF CONTENTS
CHAPTER ONE ................................................................................................................. 5
WORLDWIDE EMERGENCE OF CARRY OVER TRADES ......................................... 5
1.0
INTRODUCTION .................................................................................................. 5
1.1 CARRY TRADE CURRENCIES............................................................................. 5
1.2 EQUITY INDICES AND CARRY TRADE ............................................................ 7
1.3 CONCLUSION ......................................................................................................... 9
CHAPTER TWO .............................................................................................................. 10
CARRY OVER TRADES AND RETURNS ................................................................... 10
2.0
INTRODUCTION ................................................................................................ 10
2.1 CARRY TRADE PERFORMANCE ...................................................................... 10
2.2 CONCLUSION ....................................................................................................... 16
CHAPTER THREE .......................................................................................................... 17
CARRY OVER TRADE BUBBLE .................................................................................. 17
3.0
INTRODUCTION ................................................................................................ 17
3.1 CARRY TRADE BUBBLE .................................................................................... 17
3.2 JAPANESE MONETARY POLICY ...................................................................... 18
3.3 CONCLUSION ....................................................................................................... 18
CHAPTER ONE
WORLDWIDE EMERGENCE OF CARRY OVER TRADES
1.0 INTRODUCTION
Carry over trade is a term associated with the interest rate differential between high and
low yield currencies. As for example borrowing Japanese yen (JPY) at 0.50% LIBOR
and investing in high yield currencies like Turkish Lira (TRL) at 15.75% LIBOR. (Libor
rates as per Feb 11 2008). The exceptionally low borrowing rates attract a lot of
institutional and private investors to borrow currencies like Japanese Yen(JPY), Swiss
Franc (CHF) primarily.
Carry over trade doesn’t simply mean funding low yield currencies to buy high yield but
its has a bit more broader prospectus. Such low rate borrowings can be used to create a
portfolio or Investment fund having a wide variety of assets like Equities, Stock Indices,
Commodities, High yield currencies and Bonds. The extent to which carry over trades
progress tend to reflect investors risk appetite. The benefits of carry over trades are not
limited to capital gains but also the interest rate differential between two assets like
currencies. However there is a drawback associated which is very vulnerable and can
erode the capital gains which is known as exchange rate fluctuation. Below are the some
aspects of carry over trade fundamentals.
1.1 CARRY TRADE CURRENCIES
Over the past decade we have seen a surge in carry trades which have been funded by
Japanese Yen. In order to understand the fundamentals of carry trades it is equally
important to analyse the contribution of Yen and other funding currencies to the surge
and possible downfall of carry trades.
Due to the monetary policy of Bank of Japan(BOJ) the borrowing rate on Japanese Yen
has been at historical lows.( 0.50%). Similarly other funding currencies like the Swiss
Franc(CHF) , Euro (EUR), U.S.Dollar(USD) have been also used to diversity borrowing
exchange rate risk. On the other hand Currencies like Australian Dollar (AUD), Turkish
Lira (TRL), New Zealand Dollar (NZD), Brazilian Real ( BRL) etc have been target high
yield currencies. It is true that the recent appreciation of high yield currencies has been
spurred due to solid growth in their respective economies but at the same time we cannot
ignore the fact that carry trade has added a factor to the appreciation of high yield
currencies as well.
Below are the few Currency interest rates guide as per 12 -02-2008.
[FXCO08]
Low Yield Currencies
High Yield Currencies
Japanese Yen (JPY)- 0.50%
Turkish Lira (TRY)- 15.75%
Swiss France (CHF)- 2.75%
Brazilian Real (BRL)- 11.25%
U.S.Dollar (USD)- 3.00%
New Zealand Dollar (NZD)- 8.25%
Australian Dollar (AUD)- 7.00%
Iceland Koruna (ISK)- 13.75%
In the world of carry over trades the low yield and high yield currencies have
significantly developed a correlation among themselves. As for example if we look at the
chart below of low yield or funded currencies like Jpy and Chf their movements have
been closely associated with each other.
Source : [ SaxoBank Trader]
In a similar fashion the high yielding currencies like Turkish Lira(TRY), South African
Rand(ZAR), Polish Zloty (PLN) and Brazilian Real have highly correlated movements.
The huge move of ZAR at the end of chart which is indicated as orange is due to
instability in South African politics and is a medium term shock.
Source: [Bloomberg]
1.2 EQUITY INDICES AND CARRY TRADE
There is a high degree of correlation between Equity Indices , High Yield Currencies and
funding currencies like JPY. JPY has negative correlation with the movements of equity
indices like Dow Jones Industrial Average(DOW 30) . This is due to the fact that a lot of
investors fund their borrowings by Yen and invest in risky assets like Dow Jones. Hence
any event which triggers a steep fall or rise of Dow will trigger a opposite move in Jpy.
This is due to unwinding or carry trades. Unwinding is described as a process in which
Institutional or private investors would liquidate the positions to payoff the loan
borrowed in funded currency (Jpy). When a massive unwinding takes place, funding
currencies like Jpy and Chf can experience a sudden gain against Usd. As for example
during credit crisis July 07’
Source: [Bloomberg]
The above chart explains the correlation between a stock indice (Dow 30) indicated
yellow, High yield currency (TRY) indicated white and a low yield funding currency
(JPY) indicated orange with all the price levels on the right side of picture.
If we take any time frame we will see a positive correlation between Dow and Try and
negative correlation between Jpy and Dow. Similarly a negative correlation or price
movements can be seen between Jpy and Try.
For example on Feb 28 time scale indicative Usd/Jpy rate on chart is 117 , Usd/Try is
1.45 and Dow Jones at 12,000 area. If we move three time frames ahead to May 31 we
can see weakening Usd/Jpy (approx 121) , strengthening Usd/Try (1.33) and Dow at
13,500 area. This effect can be seen on analysing any particular time frame.
1.3 CONCLUSION
Thus in the above chapter we can conclude that most of the high yield or risky assets are
funded by low cost borrowings. This has lead to a new era of carry over trade where the
returns on them are exceptionally high. However in my theory above I have couple of
drawbacks that can erode the earnings of such risky assets. This can result due to factors
like major event risk like Credit Crisis 07’, Asian Currency Crisis 97’ and other shocks
when there is uncertainty in financial markets.
This uncertainty can lead to massive sell off of risky assets like Equity indices, Equities,
High yield currencies due to risk averseness or safe heaven buying. Risk averseness leads
to further huge fluctuations in exchange rates of currencies and volatility of risky assets
tend to increase. Situations like Credit Crisis 07’ which can be classified as major event
risk created a lot of financial imbalances which resulted in downfall of major Stock
Indices and Currencies against Jpy and Chf .
CHAPTER TWO
CARRY OVER TRADES AND RETURNS
2.0 INTRODUCTION
In this chapter, I will discuss about exceptional amount of carry interest and carry returns.
This chapter will also investigate on net long positions of some carry trades as well as
carry index performances with the help of charts and statistics sourced from Bloomberg.
Further a critical analysis on carry trade boom will be provided and whether such high
level appreciated reflects the fundamentals of respective economies.
2.1 CARRY TRADE PERFORMANCE
Statistical evidence suggests that there was a rapid growth of carry over trades since 2003.
If we compare the net long positions of Brl/Jpy and Try/Jpy between 2003 and 2008 we
can see 250% increase in Brl/Jpy longs and approximately 260% increase in Try/Jpy
longs. Below are the charts sourced from Bloomberg.
Chart-4
Net Long Positions in Brl/Jpy.
Source:[ Bloomberg]
Chart-5 Net Long positions in Try/Jpy
Similarly charts of other high yields will also depict similar increments in terms of net
long positions. Not only high yields but also Carry trade index has exceptional returns as
for example Bear Stearns Smart Carry Index shown has provided a return of 180% in 5
years time period.
In a similar fashion if we just take into account carry returns or capital gains on high
yield currencies such as Brl/Jpy longs have fetched 189% as top performing pair in Latin
America and Argentinean peso/Japanese yen (Ars/Jpy) having fetched 26.56% in 5 year
Time period.
Source:[ Bloomberg]
Carry Returns on Exotic High Yield Currencies of South America
Further Charts 7 and 8 depict the interest return on high yielding exotic currencies. This
carry trades have benefited a lot from leverage finance and thus the returns are in double
digits. Turkish Lira (Try) tops the chart with exceptional 112.39% interest return
following Brazilian Real (Brl) with 78.83%. Similar patterns of returns can be seen in
Mexico, Iceland, Poland, Hungary, South Africa etc
Source:[ Bloomberg]
Chart -7 Carry Returns on Exotic High Yield Currencies
Source:[ Bloomberg]
Chart- 8 Interest Rate Returns on Exotic High Yield Currencies
Source:[ Bloomberg]
Chart- 9
Interest Rate Returns on Exotic High Yield Currencies
2.2 CONCLUSION
In the above chapter, I have put forward the theory of carry over trades along with
statistics supporting the boom of carry trades. However it is not appropriate to conclude
that capital gains in high yield currencies are due to carry over trades and interest rate
differentials.
There is a lot of fundamental factors which support such currency appreciation. As a
majority of high yield currencies like South African Rand(ZAR), Turkish Lira(TRY),
Brazilian Real( BRL) are emerging markets. The world economy has seen solid growth
since 2003 which seems the inception period of carry over trades as well. Almost every
emerging markets have seen huge capital inflows from investors in terms of
Infrastructure development. Further Emerging markets like China, Brazil, India, Poland,
Hungary etc have seen remarkable increase in foreign exchange reserves brought as
export revenues. These increases the demand of local currency as exporters then tend to
convert the U.S. Dollar revenue to local currencies on OTC or freely floated markets.
Thus globalization and foreign direct investments have also contributed to the
appreciation of such currencies which fall in the emerging markets criteria.
On the other hand high yield currencies of Industrialised nations like Canada, Australia,
New Zealand etc have been supported by rising commodity prices. Other riskier assets
like bonds, stocks and indices have also appreciated due to much more healthier state
world economy compared to the era before 2003. Further the Federal Reserves Money
supply which according to economist survey is increasing at the rate of 11% has lead to
weakening of U.S Dollar overall and fuelling to further appreciation of world wide
currencies.
[PAGA]
Thus such capital gains on currencies, stocks and bonds cannot be solely attributed to
carry over trades and interest rate differentials. Carry over trades are just one of the
driving forces behind the boom and interest rate differentials is just one of the benefits.
CHAPTER THREE
CARRY OVER TRADE BUBBLE
3.0 INTRODUCTION
In this chapter, I will put forward facts and figures to what extent Yen carry over trade
and induced a bubble factor in global financial markets. I will primarily investigate
Japanese Yen due to its high contribution in carry trades compared to other low yields
like Swiss Franc. Further research on Japanese household’s contribution to the creation of
such carry trade bubbles will also be included. Finally I will conclude whether the carry
over trade era has ended or if there is any sign of carry trade bubble collapse.
3.1 CARRY TRADE BUBBLE
There is no official statistics to show the extent to which Yen carry trade has taken place
in financial markets but economists believe the size to be in range between $200 billion
to $1 trillion.
[FOCO07]
The Yen carry trade in currency markets is at 97% of its highest volume ever and $ 250
billion worth yen is borrowed from Japanese banks for speculative purposes.
[PAGA07]
The default Long-Term Capital Management(LTCM) due to Russian debt crisis in 1998
caused panic selling and Yen rose 20% in just 2 months. Today the number of hedge
funds have also increased and their exposure to such carry trades as well which might
give an indication of next major unwinding will be more devastating than 98’.
[WIPE07]
A huge carry trade bubble is developing in Eastern European countries where the debt
has almost surpassed the foreign reserves of countries like Poland, Hungary and Latvia.
In Poland 33 % and in Hungary 50% of mortgages have been propelled through cheap
borrowing due to high local borrowing rates. This seems to be identical to Asian Crisis
98’ where the corporate debt was funded by foreign currency and huge devaluations
resulted in crisis. The only difference here is the debt is in the form of house mortgage.
[HOCO07]
Such carry trade funding is poured into various financial assets like high yield bonds,
Currencies, Credit derivatives, Corporate loans, Real Estate and Mortgages.
3.2 JAPANESE MONETARY POLICY
Since 1998, Bank of Japan’s official lending rates have been almost 0% which has
triggered carry trades and fuelled a possible bubble factor in financial industry. Due to
extremely low interest rates Japanese household are unable to save their saving or unable
to procure returns on their savings.
Japanese investors have invested a whopping 1,500 trillion Yen in financial assets, which
is thrice the size of Japan’s GDP. The major concern here would be when Bank of Japan
would start tightening its monetary policy which may trigger unwinding of carry trades
provided the yen carry trades do not seem to be appealing. In chapter one, I discussed
about Credit Crisis 07’ which triggered massive unwinding of carry trades. Such an event
was just a small example the extent to which carry trade can have devastating affects.
[TANA07]
3.3 CONCLUSION
The above chapter gives a glimpse of astonishing facts which haunt the future of carry
over trade. No doubt the statistics mentioned earlier prove that the carry over trade
bubble is building, but it is difficult to conclude whether it is going to bust in the near
term. This is due to lack of evidence of whether long term investors have really started
unwinding the carry trades. The triggering point may be huge fluctuations in Usd/Jpy
exchange rate that will probably force investors to scale their positions. Similarly
mortgages and corporate debt funded by Yen will have to pay a hefty price for such a
carry trade strategy. When I started writing this particular research report Yen was
trading at 108.80 against the U.S. Dollar (18-02-08) and by the time I finished the
conclusion Yen hit a multi year low of 101.30 (07-03-08) on U.S recession concerns.
Indeed this gives an example of devastating affects when unwinding is taking place.
Hence in order to get a confirmation of carry over trade bubble has bust a triggering point
is essential which may be in the form of rising housing defaults or corporate debt due to
exchange rate fluctuations. But, for now its way to early to conclude and difficult to
predict the bubble is going to bust.
REFERENCES
Jeffrey Frankel, 2007, “Getting Carried Away: How the Carry Trade and Its Potential
Unwinding Can Explain Movements in International Financial Markets” Milken Institute
Review Paper, Harvard University.
“Is There A Yen Carry Trade?” Lazard Asset Management LLC, 2007.
Bank for International Settlements (2007): “Evidence of carry trade activity ”, BIS Papers,
no 14, February.
[FXCO08]
Fxstreet.com,2008, “World Interest Rates Table”[Online]. Available at
http://www.fxstreet.com/fundamental/interest-rates-table/ . Access date [12-02-08]
[ FOCO07] Forex.com,2007, “Carry trade unwinding roils currency markets”[online].
Available at http://www.forex.com/07-02-27.html . Access date [ 15-02-08]
[PAGA07]- Paul.G, 2007, “ BOE, Not BOJ, May Pop the Carry- Trade” [online].
Available at http://www.larouchepub.com/eiw/public/2007/2007_1-9/2007_1-9/20079/pdf/49_709_paul.pdf . Access date [ 15-02-08]
[WIPE07]- William.P,2007, “ Viewpoint, A Currency bubble risis in Japan”[online].
Available at http://www.iht.com/articles/2007/01/21/bloomberg/sxpesek.php Access
date[06-03-08].
[HOCO07]- Howiecopywriter.com,2007, “ The carry trade and real estate
bubble”[online]. Available at http://howiecopywriter.blogspot.com/2007/06/carry-tradeand-real-estate-bubble.html . Access date[06-03-08]
[TANA07]- Tadashi.N,2007, “ Weak Yen Conundrum”[Online]. Available at
http://www.international-economy.com/TIE_W07_Nakamae.pdf. Access date[15-02-08]
[SAXOBANKTRADER]- Saxobank.com, Online Trading Software.