FX Carry Trade: Uncovered interest rate parity states that a currency with a high interest rate should depreciate relative to a currency with a lower interest rate, so that an investor would earn the same return investing in either currency. For example, suppose that short term interest rate is 3% in UK and 1% in US. Uncovered interest rate parity implies that the GBP should depreciate by 2% relative to the USD over the coming year.
However, uncovered interest rate is not bound by arbitrage. If the GBP depreciates by less than 2% or even appreciates, an investor who has invested in the higher yielding GBP using funds borrowed in USD will earn excess profits. In a FX carry trade, an investor invests in a higher yielding currency using funds borrowed in lower yielding currency.
Example: Carry trade
Interest rate: UK 3%, US 1%
Currency pair: USD/GBP
Exchange rates: Spot rate 1.50, One year later 1.50
Compute the profit to an investor borrowing in the US and investing in the UK.
Return = interest earned on investment – funding cost – currency depreciation
= 3% - 1% - 0%
The FX carry trade attempts to capture an interest rate differential and is bet against uncovered interest rate parity. Carry trade typically performs well during low volatility periods.
Risks of carry trade: The carry trade is only profitable if uncovered interest rate parity does not hold over the investment horizon. The risk is that the funding currency may appreciate significantly against the currency of the investment, which would reduce the trader’s profit or even lead to a loss. Furthermore, the return distribution of the carry trade is not normal. It is characterized by negative skewness and excess kurtosis (fat tail), meaning that the probability of large loss is higher than the probability implied under a normal distribution. We call this high probability of large loss is crash risk of carry trade.
The primary reason of crash risk relates to the fact that the carry trade is a leveraged trade: borrowing low-yielding funding currency and investing in high yielding currency. As more investors follow and adopt same strategy, the demand of high yielding currency actually pushes its value up. However, with this herding behaviour comes the risk that all investors may attempt to exit the trade at the same time. This is especially true if investors use stop loss orders in the carry trade. During turbulent times, as investors exit their positions (i.e. flight to safety), the high yielding currency can experience a steep decline in value, generating large losses for traders pursuing carry trade.
Risk management of carry trade: There are two approaches to manging crash risk in a carry trade:
1. Volatility filter: Whenever implied volatility (implied by the market prices of options on currencies or equities) increases above a certain threshold, the carry trade positions are closed or reversed.
2. Valuation filter: A valuation band is established for each currency based on purchasing power parity or other models. If the value of a currency falls below (above) the band, the trader will overweight (underweight) that currency in the trader’s carry trade portfolio.