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Name: Course: Tutor: Date: Risk in carry trades: a look at target currencies in Asia and the Pacific The article is an analysis of the risk involved in carry trading as an investment strategy. The article examines carry trade involving five Asian and Pacific currencies-the Indonesian rupiah, Australian dollar Philippine peso, Indian rupee, New Zealand dollar and as target currencies Carry trading is a strategy that involves borrowing from one currency that has low interest rates and then investing in a currency that has high interest rates. The low interest rate currency is the funding currency and the high interest rate currency is known as the target currency. The carry trade strategy is aimed at earning from the interest rate differential or the difference in interest rates between the target currency and the funding currency since the high interest rates yield higher returns which should be sufficient to cover the interest of the funding currency with a surplus. In essence, a carry trader or carry trading investor pays interest on the currency position they sell( funding currency) and collect the interest on the currency position they buy(target currency) as earnings (Gyntelberg & Remolona 73). In order for the carry trade strategy to work, the higher yielding currency or the target currency should not depreciate at a rate equal to or more than the interest differential. This means that the uncovered interest rate parity-UIP should not hold. If the high yielding currency depreciates at a rate equal to the interest rate differential, the expected earnings from carry trading will be wiped out or the depreciation will equalize the returns. UIP offsets the interest rate differential earnings. However, evidence from empirical literature has shown that UIP is almost always guaranteed to fail in time periods shorter than five years. It has emerged that the reverse happens. That is, target currencies have actually appreciated contrary to the UIP assumption while the funding currencies have continued to depreciate. This is known as the forward premium puzzle. A study by Remolona and Schrijvers (2003) documents the failure of UIP especially when investors chose to hold investment instruments with long term maturities exceeding the investment horizon such as treasury bonds (Remolona & Schrijvers 68). Carry trading has increasingly become a preferred investment strategy in currency markets. This has mainly been as a result of the failure of UIP. Traders seem to be aware of the failure of UIP which has emboldened their resolve to incur the risks involved in carry trading since the continued appreciation of target currencies in tandem with the depreciation of funding currencies poses lucrative returns for carry trading. Carry trading as an investment strategy is also frequently pursued when the interest rate differential between the target currency and the funding currency is wide enough to compensate for the foreign exchange risk. As a result, carry trading has often shied away from using major world currencies such as the US dollar or the Euro as target currencies to ensure significant interest rate differentials. Common target currencies include the Australian dollar, South African rand, Swedish kroner and Turkish lira. Currencies managed by floating or market-based flexible exchange rate regimes such as the Brazilian real Czech koruna , Hungarian forint, Indian rupee , Indonesian rupiah and Philippine peso have also been used at times(Gyntelberg & Remolona 76). The foreign exchange risk involved in carry trading refers to the possibility of the exchange rates between the target and funding currencies appreciating or depreciating which could potentially wipe out the earnings expected from the trading currency. If for instance, the Australian dollar as a target currency were to rapidly depreciate against the Kenyan shilling (as the funding currency), a carry trader is expected to bear huge losses. This risk must be offset by an interest rate differential that is sufficient to cushion the investor against this kind of risk (Gyntelberg & Remolona 77). As an illustration of the increased popularity of carry trading as an investment strategy, the market has even introduced tradable benchmarks and indices and structured foreign exchange instruments which reference these indices. A carry trade index combines a long term position or the expected long term interest rates of one or more high yielding currencies with the short term position of one or more low yielding currencies. The indices fall into two categories with one referencing only the 10 major currencies- namely the Swedish kroner (SEK), Australian dollar (AUD), Japanese yen (JPY), US dollar (USD), pound sterling (GBP), Canadian dollar (CAD), Swiss franc (CHF), euro (EUR), Norwegian kroner (NOK) and the New Zealand dollar (NZD).The other faction references grouping of these and selected regional currencies especially Asian and Pacific currencies. The index gives the expected interest rate differential between the currency pairs Kenyan shilling (Gyntelberg & Remolona 77). To explore the nature of the risk involved in carry trading, it is first important to measure the risk. The risk is measured by constructing return distributions from ten different currency combinations from five Asia and Pacific currencies used as target currencies and two commonly used funding currencies. These combinations have been commonly used in carry trading. They can also be considered as ten different carry trading strategies. The target currencies are the Indian rupee, Philippine peso, Australian dollar, Indonesian rupiah, New Zealand dollar and the funding currencies are Japanese Yen and Swiss franc. The return distributions are constructed from daily returns provided by Bloomberg in the period from end-December 2000 to end-September 2007. To explore the nature risk, the return distributions are analyzed relative to a normal distribution and compared with stock market indices. The kurtosis, or the extent to which the returns are more peaked or flat relative to the normal distribution, is measured. A division with high kurtosis has a sharp peak at the mean and steep declines. This shows that there will be a distinct period of very high returns which will gradually decline but not beyond a certain level. The skew is also measured. A negative skew is one which has a longer tail in the negative direction or away from the peak. This shows that returns will increase slowly over a period and peak before falling rapidly (Gyntelberg & Remolona 78). The average returns for the sample carry trade strategies outperform the average returns on major stock indices. For example, the average daily returns for the carry trades funded by the Japanese Yen are almost four times than those of the S&P 500 Index between January 2001 and September 2007. The returns are higher on the pairs involving the Japanese Yen compared to that of the Swiss Franc due to the higher interest rate differentials. This is consistent with the earlier assertion that carry trading is more lucrative when there are wider interest rate differentials and shows that the Yen has lower interest rates than the Swiss franc. Analysis of the distributions shows evidence that carry trade returns are not normally distributed and are skewed negatively. This reflects what can be considered as downside risks- periods of large negative returns. It also shows another important consideration in carry trade. Currencies under fixed exchange rate regimes, the Australian and New Zealand dollars, have more profound or larger negative returns compared to those under float regimes such as the Philippine peso Indonesian rupiah and Indian rupee. This shows evidence that the risk profile of currencies under float regimes has a relatively lower downside risks. With the given distribution of the returns, there are three appropriate methods of measuring the risk involved in carry trading. The risk can be measured by estimating volatility of returns, the value at risk and the probable shortfall. The volatility of returns is the most common measure of risk. The value at risk is a computed estimate of the capital needed to cover the losses from a financial instrument. The expected shortfall is the amount over and above the value at risk for potential expected losses. Value at risk and expected shortfall are both commonly used to measure downside risk. Using volatilities and equity markets as a point of comparison, carry trades appear to be a less risky. Volatilities for carry trades in the January 2001 to September 2007 period range from 0.6 to 0.8% compared to 1 to 1.14% for equity markets. This shows that using volatilities, equity market returns are more likely to be wiped out in comparison to carry trade returns. The value at risk and expected shortfalls also show similar trends but have less differentials with equity returns as compared to volatilities. Thus measured by volatilities, carry trades appear less risky (Gyntelberg & Remolona 78). Nevertheless, the higher the risk, the higher the expected returns. An alternative measure of risk which obtains the ratio of expected returns to risk is the Sharpe ratio which is the ratio of expected return to volatility. The Sharpe ratios for carry trades consistently display better trade offs than those of equity markets. Sharpe ratios that use value at risk and expected shortfall, or measures of downside risk, also show better risk to return ratios than equity markets. However, the absolute difference is smaller compared to that of volatility. This implies that carry trade strategies are more influenced by measures of downside risk as compared to volatility. In conclusion, the ten different carry trading approaches have brought about outstanding high returns compared to their risk in terms of volatilities. Thus to accurately capture the risks involved, measures of downside risk-value at risk and expected shortfall-, are more appropriate. Using both measures leads to broadly similar risk-return tradeoffs. However, the disparity between risk-return tradeoffs for carry trade approaches and the trade-offs used to measure the same for equity markets remain wide despite of the risk measure employed. The implication is that carry trades and equity markets are priced differently because they are used in different asset classes- carry trades for currencies and equity markets for goods and services (Gyntelberg & Remolona 80). Works Cited Gyntelberg, Jacob& Remolona, Eli. Risks in carry trades: a look at target currencies in Asia and the Pacific. BIS Quarterly Review. December 2007, p 73-82. Remolona, Eli & Schrijvers M A. Reaching for yield: selected issues for reserve managers. BIS Quarterly Review, 2003 September, pp 65–74. Read More