Surviving carry trade evolution

April 28, 2016 09:00 AM

Carry trades are a method to borrow at a low interest rate and lend at a higher one. The trade is played out through the currency markets. However, currency relationships are not necessarily stable, and it’s important to analyze how a particular cross rate behaves over time.

Last month, we began a demonstration of this analysis for some popular cross rates using regression analysis to investigate how the EUR/JPY switches allegiance between the EUR/USD, USD/JPY in terms of a carry trade, particularly surrounding the 2008 financial crisis. This month we take a closer look at how the carry trade itself has evolved over time and examine how economic drivers have affected the cross-pair carry trade balance.

Anatomy of a carry trade

Carry trades are based on forex points per day, per month or per year. They answer the question of how many pips are earned to carry positions. The indispensable aspect is the trader should earn more points than are paid to be compensated enough to offset price depreciation in the long currency pair position.

The complexity of carry trades changed in 1994 when closing spot prices were marked to market; therefore, gains and losses were marked daily. Previously, forex points ran throughout the life of the contract term as traders earned the difference cumulatively without showing daily mark-to-market losses, allowing carry trade positions to be held to maturity. Losses, risk/reward and crash risk all depend on earning enough of a cushion in points to protect against adverse price developments.

Forex points are calculated from the closing spot price multiplied by the interest differential, divided by the day count, multiplied by the number of spot lots or futures contracts.

Findings suggest that carry trades contain two distinct revenue streams. One is interest differential income and the other price appreciation. Both are based on the theory of expectation. The sine qua non is to define interest differential in terms of nominal vs. real interest rates through time or in longer 20- to 50-year terms.

Price appreciation/depreciation is then defined in terms of carry trade holding periods and the length of time in trades. Essentially, a forex point is the interest differential, and is employed as a predictor of future spot prices, but it is also defined as the cost to carry positions and formally referred to as the forward discount. Currency risk is not necessarily on the investment side of the long position, but on the cost or borrow side, which may not continue to finance the long position sufficiently.

The EUR/JPY experienced temporary price and permanent interest rate depreciation pre- and post-2008. The beginning of 2000 saw EUR/JPY paying 5.75% vs. 0.50% pre-2008 vs. 0.25% and 0.1% post-2008. Carry trade losses and gains in forex points are based on the length of time in a position. Possible losses were experienced from reduced disbursements post-2008. Current price trades in excess of returns pre- and post-2008; 131.39 
pre-2008 and 121.30 post-2008.

Carry trade and EUR/JPY

The EUR/JPY is a currency pair whose position is found within the boundaries of the EUR/USD and USD/JPY. Because EUR/JPY is derived from EUR/USD and USD/JPY by U.S. dollar subtraction, boundaries must hold residual constants or the EUR/JPY transforms into a free-floating financial instrument without a connection to EUR/USD or USD/JPY.

While residual constants hold firm, the EUR/JPY may change allegiance year to year, period to period or possibly crash to crash. An allegiance switch implies that the EUR/JPY boundaries range from small to wide within EUR/USD or USD/JPY residual variances.

The assumption that the EUR/JPY maintains a perfect 0.5 balance between the EUR/USD and USD/JPY was not found; however, that does not imply a 0.5 balance is not possible. Perfect balance further implies the EUR/JPY lacks allegiance and is solely independent of EUR/USD or USD/JPY. 

An explanation of perfect balance is that the EUR/USD and USD/JPY ranges varied widely enough against each other and reached polar opposite extremes. Because EUR/USD and USD/JPY are completely opposite pairs whose relationship barely hold a statistical relationship, EUR/JPY is allowed to roam freely between both pairs. Findings suggest, however, that EUR/JPY is influenced by either the EUR/USD or the USD/JPY, but not both. So a 0.5 balance may be fleeting.

The EUR/JPY carry trade is then defined further to include either EUR/USD or USD/JPY. To view EUR/JPY exclusively in carry trade terms ignores the comprehensiveness contained within carry trades.

Money supply

A fundamental economic theory that caused EUR/JPY to change its status from pre- to post-2008 can be viewed in money supply terms, rather than as a wholesale EUR/JPY positional shift. Housing was the cause; the effect was central banks adopting quantitative easing stimulus.

As we know, interest rates share an adverse relationship to money supply. Interest rates since 2008 continuously dropped for all nations as more money was issued. Nations then experienced a Keynesian liquidity trap dilemma with countries dropping the interest rate to either zero or near zero. Low interest rates create a small price movement environment for EUR/JPY because of shrinkage of the interest differential.

Quantitative easing led to a wholesale economic change adopted by many nations as “stimulus spending,” a significant shift from previous 1980s-era supply side practices. Keynesian economics is a focus on the demand side of an economy, while its corollary focuses on supply. Both define EUR/JPY as an economic insight, a price, a carry trade and currency pair alignment.

Cross rate shift

The EUR/JPY as a carry trade is defined based on its attachment to either EUR/USD or USD/JPY, but not both. As we saw here, the EUR/JPY cross rates attachment to the EUR/USD vs. USD/JPY fluctuated throughout the 15-year period post- and pre-2008. This is evident on both weekly and monthly data (see “Crisis diversion,” below).

We examined the carry trade in the EUR/JPY by using 5,532 exchange rates, weekly and monthly, for the entire period. We saw that the perfect EUR/JPY 0.5 balance between the EUR/USD and USD/JPY was not seen over a consistent, measurable time frame, although it may have been in place during fleeting instances.

One fundamental reason why the EUR/JPY changed loyalty from the EUR/USD to the USD/JPY was a result of governmental adoption of quantitative easing (see “Switching horses,” below). If EUR/JPY had a chance to reestablish its EUR/USD attachment, the drop in interest rates and Keynes liquidity trap for all nations appeared to fail under that occurrence. By examining 12 separate data samples —much of which was shown last month as weekly data—we examined EUR/JPY loyalties and allegiance switches in a step by step approach.

Covariance was the preeminent statistic that we used to understand how and to what extent EUR/JPY transferred its loyalty from EUR/USD to USD/JPY. Slopes and regression lines served as the pictorial result to demonstrate how price traveled. The most pronounced regression lines were seen in USD/JPY, because of a complete line reversal.

While this study was limited to the relationships among three popular cross rates, the analysis should not end there. Traders in all cross rates and currencies would do well to understand the depth and consistency of the relationships between the markets they trade. Further analysis is warranted to explore how shifts in these relationships might portend price changes that may offer further opportunity to exploit market inefficiencies.

About the Author

Brian Twomey is an independent trader and author of “Inside the Currency Market: Mechanics, Valuation and Strategies.”