The first week of August was quite the moment in markets, exacerbated by overstretched positions in “short volatility”, “carry”, and “picking up pennies in front of a steam roller” type investments. These trades, characterized by frequent small gains but the potential for significant losses, were exemplified by the unravelling of the Yen FX carry trade.
So, what actually happened in early August and what potential risks does a “carry” trade, carry, hah.
What is Carry?
If we think about the total return decomposition of an asset, typically we divide it into “growth” and “income”. From a very simplistic framework, we receive a certain “coupon” such as a dividend as income, and then the changes in the price denote the “growth” of that particular asset.
Carry strategies pick assets that generate the highest yield given no changes in the underlying price. So essentially, that “income” component seen in the total return decomposition being the highest across assets within an asset class.
This strategy can be seen in all asset classes (equities, fixed-income, FX, commodities), but the most popular case is in FX, where one borrows money in a low-yielding currency (Yen) and invests that money in a higher-yield currency (USD). Below is a diagram that shows the flow of this trade:
Carry Trade Decomposed
Current Conditions:US Cash Rate: 5.25%Japan Cash Rate: 0.5%USDJPY spot rate: $1.00 = 150 Yen
Step 1
Borrow 10,000,000 Yen at 0.5%
Step 2
Convert the 10,000,000 Yen to US Dollars at the spot rate (1:150), yielding $66,666.66 USD
Step 3
Invest the $66,666.66 at 5.25% yield, with an assumed time-period of 1-year.
Step 4
1-year passes, we get $66,666.66 + 5% ($3,333.33) = $70,000 USD.
Step 5
Convert the $70,000 back to Yen (This is where it’s important that the spot rate (PRICE) has stayed similar), yielding 10,500,000 Yen.
Step 6
Pay back the 0.5% (50,000) and the initial borrowing (10,000,000), so:Profit = 10,500,000 – 10,050,000 = 450,000 Yen (4.75% yield)
Many hedge funds and professional investors utilise the leverage capacity in forex markets and hence profit more than the 4.75% in the previous example. Though with leverage comes risk, and when there is a big “unwind” as you have probably heard in the headlines over the past weeks, you can imagine the amplified effects it may have on asset prices.
What potentially happened
The Bank of Japan’s interest rate hike prompted many overleveraged investors to seek higher yields in the domestic bond market, leading to a shift away from U.S. dollar-denominated assets. As these investors repaid their loans and closed their FX carry trades, billions of U.S. dollars were converted into Japanese Yen, causing a sharp reversal in the USDJPY exchange rate (an unfavourable direction for the underlying price of the carry trade – as it’s now more expensive to trade back to the Japanese Yen).
Source: Innova Asset Management, Bloomberg
Given the widespread consensus among investors to adopt positions such as long Nikkei/TOPIX, long momentum, and short volatility, the market was primed for a potential downturn. The Bank of Japan’s tightening, which offered Japanese investors the opportunity to earn yields domestically, exacerbated this vulnerability. This shift in investor behaviour, coupled with the over positioning in these trades, led to a significant sell-off. Economic conditions, while not necessarily dire, likely contributed to forced selling by funds and institutions, further amplifying the market’s decline.
Source: Innova Asset Management, Bloomberg
After all of the position unwinding and panic, we can see that the volatility index went up and straight back down to more “normal levels” of 16. All of that for nothing, eh?
Properties and differences
On the other side of the coin, we have “long volatility” type trades which tend to payoff big when they do and can be extremely valuable to an overall portfolio solution (an example being trend-following, or simply buying options), though for the most part exhibit mild, small gains (or losses in the case of buying options). To take this “type” of investment to the ‘N’th’ degree, we have car insurance, which everyone owns – but the expected value is negative (constant losses till potentially a large payoff). In alignment with Innova’s principles of behavioural biases, investors are risk-averse, feeling more pain from losing a dollar than the happiness they gain from gaining one – and hence are happy to take on this negative expected value.
Source: Innova Asset Management, Bloomberg
A primary differentiator between these types of strategies is the hit rate, or how often you win. A more technical statistic that encapsulates the differences between these two types of strategies is “skewness”.
Strategy
Skewness
Commodity
Carry
-43%
Trend following
1%
FX
Carry
-62%
Trend following
19%
Source: Innova Asset Management, AQR Databases
For robustness, taken from a different dataset (AQR), above shows the skewness differences between their commodity and FX strategies.
Skewness tells you whether the distribution of a particular asset is symmetrical or not.
Source: Google Images
In the case of equities, they typically exhibit a “negative” skew, meaning their left “tail” is longer, though most of their value’s cluster slightly to the right of the mean – see the data since 2000 below:
Source: Innova Asset Management, Bloomberg
Final Remarks
All in all, it’s clear that carry strategies are risky during big blowups, where suddenly the underlying price of those high-yielding assets shifts in an unfavourable direction, similar to the Yen example recently. The recent unwind was amplified by the sheer amount of capital that was stacked into the FX carry trade and other “risk-on” type long positions, which lead to a huge shock to many markets. We’ve now seen that almost entirely reverse for sectors such as the S&P 500 and Nikkei, which shouldn’t be so surprising given that during those days the economic fundamentals didn’t actually change too much. Whilst FX carry and other risk premia strategies may be very valuable in a multi-asset portfolio due to their uncorrelated nature, one must understand the risks that are associated with them, and not panic when suddenly their “income” component of their total return is totally disrupted by the price changes of the underlying.
Carry carries risk
What happened in August?
The first week of August was quite the moment in markets, exacerbated by overstretched positions in “short volatility”, “carry”, and “picking up pennies in front of a steam roller” type investments. These trades, characterized by frequent small gains but the potential for significant losses, were exemplified by the unravelling of the Yen FX carry trade.
So, what actually happened in early August and what potential risks does a “carry” trade, carry, hah.
What is Carry?
If we think about the total return decomposition of an asset, typically we divide it into “growth” and “income”. From a very simplistic framework, we receive a certain “coupon” such as a dividend as income, and then the changes in the price denote the “growth” of that particular asset.
Carry strategies pick assets that generate the highest yield given no changes in the underlying price. So essentially, that “income” component seen in the total return decomposition being the highest across assets within an asset class.
This strategy can be seen in all asset classes (equities, fixed-income, FX, commodities), but the most popular case is in FX, where one borrows money in a low-yielding currency (Yen) and invests that money in a higher-yield currency (USD). Below is a diagram that shows the flow of this trade:
Carry Trade Decomposed
Many hedge funds and professional investors utilise the leverage capacity in forex markets and hence profit more than the 4.75% in the previous example. Though with leverage comes risk, and when there is a big “unwind” as you have probably heard in the headlines over the past weeks, you can imagine the amplified effects it may have on asset prices.
What potentially happened
The Bank of Japan’s interest rate hike prompted many overleveraged investors to seek higher yields in the domestic bond market, leading to a shift away from U.S. dollar-denominated assets. As these investors repaid their loans and closed their FX carry trades, billions of U.S. dollars were converted into Japanese Yen, causing a sharp reversal in the USDJPY exchange rate (an unfavourable direction for the underlying price of the carry trade – as it’s now more expensive to trade back to the Japanese Yen).
Source: Innova Asset Management, Bloomberg
Given the widespread consensus among investors to adopt positions such as long Nikkei/TOPIX, long momentum, and short volatility, the market was primed for a potential downturn. The Bank of Japan’s tightening, which offered Japanese investors the opportunity to earn yields domestically, exacerbated this vulnerability. This shift in investor behaviour, coupled with the over positioning in these trades, led to a significant sell-off. Economic conditions, while not necessarily dire, likely contributed to forced selling by funds and institutions, further amplifying the market’s decline.
Source: Innova Asset Management, Bloomberg
After all of the position unwinding and panic, we can see that the volatility index went up and straight back down to more “normal levels” of 16. All of that for nothing, eh?
Properties and differences
On the other side of the coin, we have “long volatility” type trades which tend to payoff big when they do and can be extremely valuable to an overall portfolio solution (an example being trend-following, or simply buying options), though for the most part exhibit mild, small gains (or losses in the case of buying options). To take this “type” of investment to the ‘N’th’ degree, we have car insurance, which everyone owns – but the expected value is negative (constant losses till potentially a large payoff). In alignment with Innova’s principles of behavioural biases, investors are risk-averse, feeling more pain from losing a dollar than the happiness they gain from gaining one – and hence are happy to take on this negative expected value.
Source: Innova Asset Management, Bloomberg
A primary differentiator between these types of strategies is the hit rate, or how often you win. A more technical statistic that encapsulates the differences between these two types of strategies is “skewness”.
For robustness, taken from a different dataset (AQR), above shows the skewness differences between their commodity and FX strategies.
Skewness tells you whether the distribution of a particular asset is symmetrical or not.
Source: Google Images
In the case of equities, they typically exhibit a “negative” skew, meaning their left “tail” is longer, though most of their value’s cluster slightly to the right of the mean – see the data since 2000 below:
Source: Innova Asset Management, Bloomberg
Final Remarks
All in all, it’s clear that carry strategies are risky during big blowups, where suddenly the underlying price of those high-yielding assets shifts in an unfavourable direction, similar to the Yen example recently. The recent unwind was amplified by the sheer amount of capital that was stacked into the FX carry trade and other “risk-on” type long positions, which lead to a huge shock to many markets. We’ve now seen that almost entirely reverse for sectors such as the S&P 500 and Nikkei, which shouldn’t be so surprising given that during those days the economic fundamentals didn’t actually change too much. Whilst FX carry and other risk premia strategies may be very valuable in a multi-asset portfolio due to their uncorrelated nature, one must understand the risks that are associated with them, and not panic when suddenly their “income” component of their total return is totally disrupted by the price changes of the underlying.
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