Borrowing Low-Yielding Currencies to Buy High-Yielding Currencies Works, Until It Doesn't
The concept is pretty simple: Borrow a currency with a relatively low interest rate, purchase a currency with a relatively high interest rate, and pocket the difference. This is the currency carry trade, one of the more popular strategies of hedge funds.
This presents a conundrum. On one hand, uncovered interest rate parity (UIP) theory says expected returns should be equal for otherwise comparable financial assets denominated in two different currencies. Thus, the low-yielding currency should have the same expected return as the high-yielding currency. However, there's overwhelming empirical evidence against the UIP theory. Thus, we have what's known as the UIP puzzle.
One possible explanation is that the risk premium of the carry trade varies over time. The authors of the study "The Time-Varying Systematic Risk of Carry Trade Strategies," analyzed this potential explanation.
The study followed the explicit strategy of Deutsche Bank's PowerShares DB G10 Currency Harvest Fund (DBV). The portfolio:
- Has a long position in the three currencies with the highest interest rates
- Has a short position in the three currencies with the lowest interest rates
- Is rebalanced quarterly
By examining variables such as foreign exchange volatility, the VIX (a measure of the implied volatility of S&P 500 Index options) and either market or funding illiquidity (the bid-ask spread and the TED spread), the study authors found that the currency carry trade is exposed to the risks of the stock and bond market and to the risk of volatility in the foreign exchange market. In other words, its success is regime dependent.
They also found that all individual currency returns have fat tails, creating the potential for large losses during times of crisis. Thus, investment currencies lose value against funding currencies when the risk appetite of investors decreases and they move to safe assets such as US Treasury bonds.
These results shed light on the gamble that is currency speculation. In turbulent times, the systematic risk of the carry trade significantly increases as does its exposure and its correlation to other risky assets also increases. This finding warns against the apparent attractiveness of the carry trade as depicted by simple performance measures such as the Sharpe ratio. In other words, on average, the carry trade strategy yields positive and moderately high returns in normal periods. However, the carry trade, on average, shows dramatic losses during turbulent periods.
The findings from this study are consistent with the findings from the study "Carry Trades, Momentum Trading and the Forward Premium Anomaly" that appears in the August 2011 edition of The Journal of Financial Markets.
In general, investors are risk averse. And they care about more than just volatility. They also care about whether the distribution of returns is normal (shaped like a bell curve). In particular, they dislike assets whose distribution of returns exhibit negative skewness and excess kurtosis (fat tails). When these attributes are present, there's the potential for large losses. In other words, strategies that have these characteristics are akin to picking up nickels in front of steamrollers -- you can have a long run of small gains, but eventually get squashed. The evidence suggests that the currency carry trade has these characteristics.
The negative skewness and excess kurtosis result from the carry trade's exposure to the stock market and bond markets. The result is that risks to the strategy increase at the wrong time, when there are increases in the volatility of markets.
Photo courtesy of bradipo on Flickr.
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