SPECIAL REPORT carry trade

The profits of carry

The carry trade has come under sustained pressure during the recent period of increased
volatility. Ivan Petej analyses the source of returns on carry trade strategies and assesses its
likely profitability in the current environment

Over

the past decade, currency

management has progressively shifted from being viewed as a
source of risk to what many absolute
investors have always believed a source
of sustainable and uncorrelated returns.
As a result, institutional investors, as well
as private individuals, are increasingly
considering currency as an asset class in
its own right. In response, the universe of
currency managers has grown and so has
the distinction between the classifications
of their investment styles.
One of the more commonly known
investment styles within the currency
industry, and certainly one of the most
debated, is the carry trade (also known as
forward bias). In fact, such is its popularity over the past few years that various
forms of foreign exchange instruments
were created and made available to the
general public via exchange-traded funds
and structured notes. The aim of this
article is to discuss the persistence of carry
and offer some forward-looking guidance
on the likely outlook for currency
investment styles in general.
A carry investment style in the
currency market involves the purchase of
higher-yielding currencies versus their
low-yielding counterparts. One of the
more popular rationales for discussing
the returns on currency trades is from

1 Base Volatility Index (LHS) and G-3 currency

volatility (RHS, one-month option implied)
0.6
0.4

Base Volatility Index (LHS)

G-3 currency volatility (RHS)

0.2

21
19
17

15

0.2

13

0.4
0.6

11

0.8

7
1.0
Jan 90 Jan 93 Jan 96 Jan 99 Jan 02 Jan 05 Jan 08

58

contributed.indd 58

the perspective of the efficient market

hypothesis (Burnside et al, 2006). This
implies the return gained from the
interest rate component of buying a
high-yielding versus low-yielding
currency should be exactly offset by the
subsequent moves in the spot price in the
opposite direction.
Contrary to the efficient market
hypothesis, the carry investment style has
been found to be empirically profitable
(Galati, Heath & McGuire, 2007). A
number of theories have been proposed to
explain this apparent inefficiency. The
persistence of any returns in the currency
investment universe is indeed inefficient,
but only if currencies are viewed as a closed
system with rational investors who have
similar time horizons, are indifferent to
risk and have perfect access to information
(Remolona & Schrijvers, 2003). However,
as has been proven historically, currency
investments are far removed from such an
idealised simple scenario.
Let us consider carry from the perspective of a purely rational investor. The
purchase of any asset involves the balance
between return and risk. In the case of
equities, the return on a stock purchase is
related to the dividend payout, assuming
the price of the stock is unchanged. By
analogy, the return on a purchase of a
high-yielding versus low-yielding
currency is related to the interest rate
differential between the two, so long as
the spot rate remains unchanged. The
carry trade, therefore, involves the
balance of risk between the risk-free
return and downside volatility risk over a
given time horizon, be it for a systematic
or discretionary currency investor.
A simple strategy of buying the three
highest-yielding and selling the three
lowest-yielding currencies within the
G-101 universe, rebalanced monthly, and
measured over the past 20 years shows
that the greatest proportion of returns over
the past two decades can be attributed to

the interest rate component. From a purely

investment perspective, therefore, the
interest rate differential can be viewed as a
risk premium associated with the downside
risk of significantly negative spot returns.
This downside risk can be characterised by
two components financial market
volatility and liquidity.
Historically, and as has been seen since
the credit crisis from the third quarter of
2007, carry trades have tended to underperform in periods of heightened financial
market volatility, precisely because the
returns gained from the interest rate
component become negligible as a result of
the potential losses through movements in
the spot price. Over the past two decades,
a considerable amount of research has been
conducted to account for and predict both
the level and the likely change of volatility
(Bank for International Settlements,
2006). The relative surprise with which the
recent market events affected many
financial institutions, however, indicates
that accurate volatility prediction still
presents a challenge.
One of the more popular methods of
volatility estimation, in part adopted by
systematic investment styles, uses
historical returns, option implied
volatilities or any other price indicators to
extrapolate into the future. At Principal
Global Investors (PGI), we use a proprietary indicator called the Base Volatility
Index, which differs from the traditional
approaches. Rather than forecasting
financial market volatility itself, it is an
indicator of various fundamental-based
preconditions for a rise in financial
market volatility, and hence is forward
looking. The indicator, shown in figure 1,
consists of an overall indicator and a series
of sub-indexes aimed at analysing the
fundamental preconditions separately.
The choice of sub-indexes reflects our
understanding of what causes financial
1
G-10 refers to the following currencies US$, , , , Sfr, A$,
C$, Skr, Nkr, NZ$

Foreign exchange August 2008

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carry trade SPECIAL REPORT

2 Annual information ratio of simple carry strategy (threeyear average) (LHS) and the Base Volatility Index (RHS)
1.0
0.8

Three-year avg annual IR for simple carry (LHS)

Base Volatility Index (inverted RHS)

0.6
0.5

0.6
0.4

0.4
0.3
0.2

0.2
0
0.2

0.1
0
Jan 96

Jan 98

Jan 00

Jan 02

Jan 04

Jan 06

0.4
0.6
Jan 08

market volatility (including foreign exchange volatility) to rise and

fall. Higher values correspond to conditions likely to generate
higher uncertainty of returns, with a historical threshold of 0.2
and above (grey shaded area in figure 1) indicating preconditions
for a significant increase. As can be seen from the graph, the
composite index tracks G-3 currency volatility reasonably well and,
as early as the start of 2007, was signalling a less favourable
volatility environment.
When viewed in the context of sub-indexes, the recent rise in
financial market volatility can mainly be attributed to the
deviation of the valuation component, driven until recently by the
excessively tight credit spreads, flat yield curves and a combination
of abnormally polarised exchange rates and current account
deficits. The rise since the third quarter of 2007 is related to the
component linked to global monetary policy uncertainty.
Simultaneously, however, macroeconomic volatility is still
relatively low. Having spiked during the Asian crisis in 1997/98
and then climbed again during the global recession in 2001/02,
macroeconomic volatility has decreased significantly and
remains low by historical standards.
In this context, our outlook for the next phase in financial
market volatility is a likely rise in macroeconomic volatility
arising from unsteady growth, inflation and unemployment
not just in the US, but globally. Figure 2 shows the index level
plotted against the annualised three-year average information
ratio of the simple carry trade. There is a direct relationship
historically, and given the current level of the index, we expect
the interest rate return as a compensation for the level of spot
volatility to diminish further in the months to come.
The information ratio analysis assumes that when volatility
rises, currency spot returns follow a simplified normal distribution. However, the non-normality of most financial instrument
returns, including currency, is an empirically observed fact. This
relative non-normality (or tail risk) of price-return series of
various currencies presents additional downside risk, which goes
beyond the simple carry-to-risk ratio. A recent study analysed
these risks in target currencies in Asia-Pacific (Gyntelberg &
Remolona, 2007). In this article, we analyse the risks across the
G-10 currencies and show this non-normality presents a further
risk premium that is embedded in the interest rate differentials.
Before we embark on a statistical analysis, let us focus briefly
on assessing currency liquidity. Although currencies are by far
the most actively traded instrument globally, the liquidity of
currencies in general is difficult to measure directly due to the
fact that foreign exchange transactions are mostly traded directly
between counterparties rather than on a registered exchange.

contributed.indd 59

Omega (daily >1.2% threshold) (%)

0.8
0.7

3 Relationship between the average interest differential

versus downside risk (measured as weighted-probability
of returning less than 1.2% daily) for G-10 currencies
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0

6
3
4
2
5
Average interest rate vs. yen (%)

One of the commonly used references is the triennial report published by the Bank for International Settlements (BIS). According to the latest BIS report, published in 2007, the daily foreign
exchange turnover is estimated as $3.2 trillion (Triennial
Central Bank Survey of Foreign Exchange and Derivatives
Market Activity, 2007). Given such a high turnover, it is
interesting to compare the relative liquidity, measured by traded
volume, across different countries.
Table A shows the relationship between the total traded
volume, GDP and the average cash interest rate for the corresponding countries over the past two decades. There is a general
trend for less liquidly traded currencies, with lower GDP, to
exhibit a higher average interest rate historically.
Given the BIS measure, it is instructive to check whether
currencies with lower liquidity according to the BIS also exhibit
greater downside risk. There are various statistical methods that
can be applied to test for the empirical tail risk of financial
return distributions. One of the more recent popular methods
proposed for measuring the non-normality of financial assets is
the use of the omega function (Shadwick & Keating, 2002).
Using varaince as the sole measure of risk implicitly assumes
asset prices are normally distributed. However, the omega
function samples all moments of the distribution simultaneously
and hence can be intuitively directly interpreted in financial
terms. The omega measure is not parametric, but is calculated
directly from the observed distribution and requires no estimates, and hence measures the downside risk directly.
Omega is simply defined as the ratio of the probability-weighted
cumulative returns above a certain threshold. A higher value of
omega is therefore a direct measure of a higher ratio of probability

A. BIS volume, GDP and average three-month cash rate (19872007)

for the G-10 currencies
Currency

% of BIS reported volume

GDP ($bn)

Average 3m cash rate (19872007) (%)

US$

86.3

13,794

4.8

37.0

11,197

4.6

16.5

4,346

1.9

15.0

2,756

7.1

Sfr

6.8

414

3.0

A$

6.7

890

7.6

C$

4.2

1,406

5.7

Skr

2.8

432

6.8

Nkr

2.2

369

7.3

NZ$

1.9

124

8.7

risk.net

59

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SPECIAL REPORT carry trade

4.0

NZ$

3.5
3.0
2.5
2.0

5.0
4.5
4.0
3.5
3.0
2.5
2.0
1.5 US$
1.0
0.5
0
0

1.5
1.0
0.5
0.1

0.2

0.3
1/% volume

0.4

0.5

0.6

of returns below a certain threshold to that above a cerain threshold. When the threshold is set sufficiently low (that is, equal to the
mean return minus the 99% of the normal distribution), a value of
omega above 1/99 = 1.01% is a signature of additional downside
risk compared with the simple normal distribution estimate.
To compare the downside risk of a simple carry strategy, we
calculated the omega values using daily currency spot return data
from September 1993 to December 2007 for all the G-10 currencies
versus the yen. The yen was chosen as the base currency due to the
fact it exhibited the lowest average yield over this period, and is the
most commonly used funding currency for carry trades in general.
The average daily standard deviation of spot returns was in the
range of 0.6% (for Swiss franc/yen) to 0.8% (for New Zealand
dollar/yen). The threshold of return was therefore set at a value
significantly greater than the standard deviation, at 1.2% daily,
in the direction of appreciating yen, that is, in the opposite
direction to the carry trade.
Figure 3 shows the plot of the measured omega values versus
the average interest rate differential with yen as a base currency.
On average, there exists a general trend in which currencies with
higher interest rate differentials also exhibit a greater probabilityweighted drawdown.
Figure 4 shows the relationship between the measured
downside risk (in this instance divided by the daily standard
deviation) and the inverse of the percentage of traded volume as
reported by the BIS. Currencies with lower overall traded
volume (and hence liquidity) exhibit higher downside return risk
for the same underlying level of realised standard deviation.
This relationship between the interest rate differential,
liquidity and the corresponding downside risk suggests currency
investment in smaller economies within the developed world
provides a higher general interest rate return, partly as a form of
compensation for the lower relative liquidity and corresponding
downside risk of owning them.
Furthermore, this downside currency risk has an increasingly
important effect at elevated volatility levels. To see this, we can
compare the contribution of excess downside risk (measured as
the downside risk beyond the ninety-ninth percentile estimated
by the normal distribution) and the average daily standard deviation. Figure 5 shows this relationship for the most polarised
carry pair of the three in the G-10 universe (highest versus
lowest yielding), using a one-year rolling window.
At lower overall volatility levels, when the standard deviation

60

contributed.indd 60

5 Relationship between standard deviation (red RHS)

and total probability of return below the implied mean
less 99% (blue, LHS) (G-10 highest vs. lowest yielding,
one-year rolling window)

0
1987

2.0
1.8
1.6
1.4
1.2
1.0
0.8
0.6
0.4
Prob of return below mean less 99% percentile (LHS) 0.2
Daily standard deviation (RHS)
0
2002
1992
2007
1997

Omega/daily standard deviation

4 Relationship between the inverse of the percentage

volume reported by BIS (2007) versus downside risk
(measured as weighted-probability of returning less than
1.2% daily, normalised by volatility) for G-10 currencies

of returns to carry is low and a simple carry-to-risk ratio is

attractive, the non-normal exhibited downside risks are very low.
On the other hand, when the average volatility is elevated, the
probability of returning less than the ninety-ninth percentile
implied by the standard deviation becomes significantly higher
than 1%. At low volatility levels, therefore, the interest rate
differential is generally the most important factor in picking the
currency pairs, whereas when volatility is elevated, liquidity
becomes a more significant issue.
Conclusion

From our current perspective, in line with the rise in our Base
Volatility Index and the likely impact on downside risk for carry
trades, we forecast a decreasing attractiveness of the interest rate
return component in comparison with the low volatility
environment that characterised the past four years leading up to
August 2007, particularly for currencies with lower relative
liquidity. With volatility rising, timing becomes an everincreasing component for successful currency management, and
a forward-looking style is generally complementary to the type
of market conditions where historical financial market volatility
becomes an ever-decreasing prediction of the future realised. n
Ivan Petej is a currency analyst at Principal Global Investors. Email: Petej.Ivan@
principal.com

References
Bank for International Settlements,
2006
The recent behaviour of financial
market volatility
BIS paper 29, August
Burnside C, M Eichenbaum,
I Kleshehelski and S Rebelo, 2006
The returns to currency speculation
NBER working papers 12489, August
Galati G, A Heath and P McGuire,
2007
Evidence of carry trade activity
BIS Quarterly Review, September

Gyntelberg J and E Remolona, 2007

Risk in carry trades: a look at target
currencies in Asia and the Pacific
BIS Quarterly Review, December
Remolona E and MSchrijvers, 2003
Reaching for yield: selected issues for
reserve managers
BIS Quarterly Review, September
Shadwick W and C Keating, 2002
A universal performance measure
Journal of Performance Measurement,
spring
Triennial Central Bank Survey of
Foreign Exchange and Derivatives
Market Activity, 2007
December

Foreign exchange August 2008

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