In a yen carry trade, a trader borrows Japanese yen at low interest rates and invests the principal in a higher yielding currency. As long as nothing happens, the trader earns the interest rate differential (the carry) and is able to repay the yen loan with the principal from his investment. The risk is that the yen strengthens.
Because the yen carry trade would appear to have been a source for so many profits, its impending death has been the source of much speculation. The fear is that an outrageous number of traders are positioned similarly and enough concern about a stronger yen will spark a stampede to unwind the trade. A crucial question then is how great are the total carry trade positions in the market and has this activity changed recently.
To assess this we examined the relationship between hedge fund returns and hypothetical carry trade strategies. If hedge fund returns are unusually dependent on the carry trade, the logic goes, there are a greater number of traders apt to rush to unwind should the trade sour. To find hedge fund exposure to the carry trade, we perform rolling 24-month regressions of hedge fund indexes on a combination of standard fixed income factors and the returns on four hypothetical carry trade strategies. All of the strategies borrow yen and invest respectively in the U.S. dollar, Australian dollar, Brazilian real and Taiwanese dollar. The maturity and the size of the carry trades implemented are based on the carry-to-risk ratio, that is, the ratio of the interest rate spread to the exchange rate implied volatility.
In “Carry exposure,” below, we plot the regression coefficient for each of the carry trade strategies, and emphasize the points (bold) in time where the coefficient was statistically significant at 95% confidence. Our analysis suggests a general positive exposure to the various carry trades.
The Market Timing Index begins to show a correlation in late 2001 and appears to derive a significant and growing portion of its returns from the various carry trades peaking in 2003. Since then it has been lower but positive and relatively stable. The HFRI Fund of Funds Composite and Global Macro indices demonstrated similar behavior.
The HFRI Fixed Income Total index shows a consistent reliance on the carry trades until 2002, and then peaks off exposure to the BRL in 2003 and the AUD in 2004 and 2005. Since 2005 there appears to be significant negative exposure to three of our strategies. This implies that the funds comprising this index are positioned to profit from a possible unwind scenario. Other fixed income HFRI indices corroborated this.
It appears, then, that there are categories of hedge funds that are relying on the carry trade — though less than in the past — while there are other categories of hedge funds that appear positioned oppositely. Our analysis does not show large systemic exposure.
Christopher C. Finger is head of research for RiskMetrics Group, Europe. He can be reached at chris.finger@riskmetrics.com.
