Dumb Alpha: Don’t Get Carry Traded Away
In the last installment of this series, I considered momentum investing strategies. These momentum strategies work quite well in practice, but are prone to so-called momentum crashes — i.e., sudden dramatic changes in the direction of asset prices. Avoiding one of these crashes is key to successful asset management.
Close cousins to traditional momentum strategies are carry trades. In a carry trade, an investor borrows money in a currency with low interest rates, for example, the Swiss franc or the Japanese yen, and invests the proceeds in a currency with high interest rates, like the Australian or New Zealand dollar. With these carry strategies, investors can benefit from the higher interest income but take on the risk that the high-interest currency will depreciate against the low-interest currency.
Carry trades profit from investor herding just like momentum strategies. As more and more investors pour money into high-interest currencies and borrow on low-interest currencies, the demand for high-interest currencies rises, leading to appreciation of these currencies over time. As a result, carry trades lead to a self-enforcing cycle in which investors benefit not only from higher interest income in some currencies, but from the gradual appreciation of these currencies against low-interest currencies.
Currency Crash and Carry
This herding behavior can continue for quite some time, but it comes to a halt when investors are no longer willing to invest in high-interest currencies. When this happens, carry trades unwind very quickly, and investors witness a currency crash.
These currency crashes can come from out of the blue. For example, between 5 October and 9 October 1998, the US dollar suddenly depreciated against the yen by 13%, and the Australian dollar depreciated by about 10%. What was surprising about this episode was that it was not triggered by any fundamental news about the countries. The old trader adage, “Currencies go up with the stairs and down with the elevator,” came true once more, causing heavy losses for many carry investors.
It can be even worse if currency crashes are triggered by fundamental events. On 15 January 2015, the mother of all currency crashes occurred when the Swiss National Bank lifted the minimum exchange rate to the euro, creating a sudden appreciation of the Swiss franc by 18.8% versus the euro. This massive appreciation of the Swiss franc brought several FX brokerage firms to the brink of collapse.
Crowded Carry Trades: Greed Isn’t Good
Luckily, Geert Bekaert from Columbia Business School and George Panayotov from Hong Kong University recently proposed a simple way to profit from carry trades while keeping the crash risks to a minimum: Instead of investing in carry trades with the most extreme interest rate differentials, one should invest in the less-crowded trades between currencies in the middle of the interest rate range.
Take, for instance, the G-10 currencies. These are the most traded and liquid currencies in the world. A typical carry trade consists of investing in the currency with the highest interest rate — typically the Australian or New Zealand dollar — and borrowing in the currency with the lowest interest rate — usually the yen or the Swiss franc. Such carry trades are bad according to Bekaert and Panayotov, however, because they are driven by investor greed and thus become excessively crowded. If carry trades start to unwind, any crash is concentrated in these currencies.
Instead of investing in currencies with extreme interest rate differentials, Bekaert and Panayotov find that investing in good carry trades between currencies in the middle of the pack is the better choice. Imagine, for example, that an investor borrows in the euro or Swedish krona, two currencies with a higher cost of borrowing than the Swiss franc or yen. The proceeds from these loans are then invested in British pounds or Norwegian krona, two currencies with higher — but not extremely high — interest rates. Investors in such good carry trades gain less on the interest rate differential than investors in the traditional carry trades, but if a crash occurs, they also suffer less because they are not caught in overcrowded trades with too many investors scrambling for the exit. The results of such a strategy are lower crash risks and higher risk-adjusted returns.
Simply put, being less greedy seems to be an effective way to avoid crash risks in currencies.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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