Thursday, 1 May 2014

Carry Creep and Risk Reversals

One of the characteristics of carry trades which extends through to many emerging markets and even the quiet function of equity markets (never sell a quiet market) is their tendency towards "carry creep". In absence of all other information prices will generally creep on up as the carry benefit of either interest rate differentials or dividend payments makes them continually more beneficial to own than the alternative. But the question is always how far can price go up before it outweighs the carry advantage.

With respect to equities, yields fall with price rises to naturally stabilise the price rallies around some sort of equilibrium - unless the function of future expectations swamps yield differentials and we head of into another reasoning that ends up as it happens with the same price action.

But with FX the interest yield differential is maintained no matter what the entry price is. The self levelling function then is dependant upon a more complex route of the secondary damage of runaway FX rates to core economies which has a natural lag involved. That lag is when things start to heat up and a prime example is the Aussie Dollar where yields were being driven by high rates maintained to control an economy booming on the back of mining during the commodity boom. It led to the central bank wanting FX rates lower but the currency only really fell once the China slowdown hit future mining outlook and the risk of holding the carry was felt to be greater than the benefit. At which point the carry trades started to unwind as price volatility vs return thresholds were tripped.

But in general without any other external inputs FX will be subjected to carry creep before an exogenous shock trips prices dramatically lower with carry unwinds accelerating the pace. So though the total price rise as money goes in will, all else being equal, equal the price fall coming out, the pace will be very different. And hence we get our classic sawtooth price action.

But how do we play a sawtooth? If there is, for example, an 80% chance of making 2.5% on the up creep but a 20% chance of losing 10% on the down fall then the game looks pretty flat. But things might be different if you use options to take advantage of speed differentials and the use of risk reversals has always been a conceptual favourite of mine when it comes to trading carry creep. With the idea being that you pick a shortish period, say a week, and extend the carry creep line that price has been following to the expiry date and sell a call with strike above that line and meanwhile buy a downside put for the same premium you receive. A zero premium risk reversal. This will either hopefully expire within the strikes and not have cost you anything, or in the case of the dump, have smashed through your lower strike leaving you a tidy profit. If it hasn't paid off and price is higher but within strikes at maturity just reset with new higher strikes. Something like this

But there are some naturally self limiting functions that will undermine the benefits. First that you will be pricing against the forward which if the yield is high (why you are going in) will mean that the stretch between call and put strike is already against you and then there is the function that you are probably not the only person to work this trade out and the market is already pricing it away. In equities puts always tend to price over calls and the example is interesting in AUS where a put bias was dramatically present all the way up to the point that some were arguing that as AUS was no longer an emerging currency it didn't deserve to have puts so skewed over calls. As it turned out - it did. But this was more due to its carry component rather than any other EMness (though of course the ability to liken Australia to an EM is often too great for a Brit to resist).

But despite the normally skewed pricing, it could well be flatter than your fears and as an alternative to running carry costs directly against yourself via a cash short, this might be an alternative. It is certainly worth looking at when you have the saw-tooth dilemma worrying you that though the trend may be your friend it might be about to run off with your wife.

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