Controlling Carry Exposures (Summary)

The currency carry trade (or carry trade), where investors pocket the difference between borrowing in low-yielding currencies and investing in high-yielding ones, has become an established investment strategy and a source of enduring returns.

Older investors may associate the carry trade with the Japanese economic downturn in the early 1990s and the near-zero interest rates in Japan ever since. For nearly a decade, investors exploited a strategy that seemed riskless—borrowing in low-yielding Japanese yen to fund higher-yielding investments in other currencies. That trade proved disastrous when the yen rose. Investors who had borrowed yen were forced to buy it back at much higher prices, thereby incurring large losses.

The authors focus on the downside risks of carry trades in both developed and emerging markets by cataloguing the major carry losses of recent times, with the aim of evaluating what contributes to these losses, known as drawdowns. In particular, the authors consider the duration of carry drawdowns—how long carry drawdowns persist—an aspect of carry trade research that has been neglected. By developing duration analysis, the authors believe they can help portfolio managers decide whether to exit their positions once a carry trade starts to go bad.

The authors analysed the worst episodes of currency carry losses in recent decades, with the aim of finding to what extent the length of the episode of carry losses contributed to carry drawdowns. They also considered currency and timing as potential contributors.

Carry drawdowns and their causes were assessed in both developed and emerging markets. For developed market currencies, the authors backtested carry trade returns from December 1983 to August 2013. For emerging market currencies, the sample was much shorter, starting in February 1997.

To identify the causes of the length of carry losses, a subject that has not been explored before, the authors produced a model of estimated carry drawdown length. This model incorporates three variables the authors believe could be influencing the length of carry drawdowns: financial stress, the carry opportunity set, and a measure of spot exchange rate valuation.

First, given that carry trades tend to perform poorly in times of market stress, the authors used a financial stress index to measure financial conditions over time. Second, they examined the expected return on the carry trade at the onset of the drawdown. Third, they explored the size of deviations from a fundamental value (defined by purchasing power parity) portfolio of the carry-related portfolio holdings.

Perhaps unsurprisingly, the largest carry drawdown in developed markets is associated with the financial crisis of 2007–2009. The longest drawdown occurred from 1992 to 1995 and was associated with the European Exchange Rate Mechanism (ERM) crisis. In emerging markets, the longest drawdown was from 2011 to 2013, in the aftermath of the financial crisis.

Certain currencies appear frequently as major contributors to drawdowns. In developed markets, these are the Australian and New Zealand dollars, the Japanese yen, and the Swiss franc. A different dynamic is seen in emerging markets, where the major contributors are the Indonesian rupiah, the South African rand, the Turkish lira, and the Brazilian real. Most emerging market currencies depreciate against the US dollar in drawdown periods.

Each of the three duration variables were found to correlate strongly with the length of drawdown. The greater the stress in financial markets, the longer the length of the drawdown. The higher the carry opportunity at the start of the drawdown, the longer the drawdown lasts. The greater the exchange rate misvaluation at the start of the drawdown, the shorter the length of the drawdown.

When faced with a carry drawdown, the investor’s challenge is to decide whether to hold on to positions in the hope that the drawdown will soon reverse or cut carry exposures in the belief that the drawdown will persist. This study helps investors manage this challenge by creating a fully implementable model to manage their carry trade exposures when the model signals a longer period of loss.

At least according to the historical data chosen in this study, the probability of a drawdown lasting beyond a certain number of days can be estimated. A portfolio manager might use this estimated probability to assess how long a carry drawdown is likely to last and to decide whether to reduce carry exposures. As no one wants to be last out of the door in the case of a drawdown, the model’s ability to account for the level of crowding and misvaluation levels of the exchange rates at the start of trades could be valuable to investors.

Overall, the study should help investors mitigate carry-related losses and improve investment performance. Managers of carry portfolios and their underlying investors should pay heed to the finding that drawdowns overall have become larger in both developed and emerging markets since the onset of the financial crisis. Interest rate convergence may have temporarily reduced the opportunity set for carry trades, which may make some investors wary of carry trades until interest rates start to diverge once again.