Swedroe: The Risks Of Carry Trade

The carry trade may be all the rage, but understanding its risks is essential.

The carry-trade strategy involves borrowing (going short on) a currency with a relatively low interest rate and using the proceeds to purchase (going long on) a currency yielding a higher interest rate, capturing the interest differential. The strategy can be “enhanced” though the use of leverage.

The success of this strategy has led to its proliferation, despite it being at odds with economic theory. Uncovered interest parity (UIP) theory states that there should be an equality of expected returns on otherwise-comparable financial assets denominated in two different currencies.

Thus, according to UIP, we should expect an appreciation of the low-yielding currency by the same amount as the return differential. However, there’s an overwhelming amount of empirical evidence against UIP theory. Thus, we have what is known as the “UIP puzzle.”

Important Research

Martin Lettau, Matteo Maggiori and Michael Weber—authors of the study “Conditional Risk Premia in Currency Markets and Other Asset Classes,” which appears in the November 2014 issue of the Journal of Financial Economics—provide us with a risk-based explanation for the success of the carry trade. Their study covered the period January 1974 through March 2010 and more than 50 currencies.

The authors found that “while high-yield currencies have higher betas [exposure to equity market risk] than lower-yield currencies, the difference in betas is too small to account for the observed spread in currency returns.”

However, since investors are known to exhibit downside-risk aversion, they extended their research to include a downside risk capital asset pricing model (DR-CAPM). They found that the DR-CAPM does indeed price the cross-section of currency returns.

Specifically, they found that the overall correlation of the carry to trade to beta is 0.14, and that it is statistically significant, with most of the unconditional correlation due to the downstate. Conditional on the downstate, the correlation increases to 0.33, while it’s only 0.03 in the upstate.

Returns Explained

They also found that while the correlation of high-yield currencies with market returns is a decreasing function of those market returns, the opposite is true for low-yield currencies. The low-yielding currencies benefit from a flight to quality in bad times. They discovered that the DR-CAPM explained about 85 percent of the cross section of returns.

The authors thus concluded that “high yield currencies earn higher excess returns than low yield currencies because their co-movement with aggregate market returns is stronger conditional on bad market returns than it is conditional on good market returns.”

They also found that this downside risk premium is a feature not only of currencies, but also of equities, commodities and sovereign bonds. The authors’ findings are aligned with standard asset pricing theory, which posits that investments tending to perform poorly in bad times should carry risk premiums.

These findings are consistent with that of prior research. Following is a review of the recent literature on the carry trade.

Research Review

1. Lucio Sarno, Paul Schneider and Christian Wagner—authors of the 2011 study “Properties of Foreign Exchange Risk Premiums”—concluded that risk premiums solve the UIP puzzle and explain the success of the carry trade. They found that:

• Time-varying excess returns are compensation for both currency risk and interest-rate risk. High interest rate currencies depreciate, on average, when domestic consumption growth is low (such as in 2008), while low interest-rate currencies appreciate under the same conditions.
• Financial and macroeconomic variables are important drivers of the foreign exchange risk premium.
• Expected excess returns are related to global risk aversion. In times of global market uncertainty and higher funding liquidity constraints, investors demand higher risk premiums on high-yield currencies, while they accept lower (or more negative) risk premiums on low-yield currencies. This supports flight-to-quality and flight-to-liquidity arguments for the risk premium in the carry trade.
• Expected excess returns are countercyclical to the state of the U.S. economy. The authors concluded that “foreign exchange risk premiums are driven by global risk perception and macroeconomic variables in a way that is consistent with economic intuition.”

Link To Volatility

2. Hanno Lustig, Nikolai Roussanov and Adrien Verdelhan—authors of the 2011 study “Common Risk Factors in Currency Markets”—found that the carry-trade premium is related to changes in global equity market volatility. High (low)-interest-rate currencies tend to depreciate (appreciate) when global equity volatility is high.

They concluded that the price of volatility is negative, and statistically significant. In other words, by investing in high-interest-rate currencies and borrowing low-interest-rate currencies, U.S. investors are loading up on global risk.

Forex Volatility

3. Lukas Menkhoff, Lucio Sarno, Maik Schmeling and Andreas Schrimpf—authors of the 2011 study “Carry Trades and Global Foreign Exchange Volatility”—found that more than 90 percent of the cross-sectional excess returns from the carry trade were explained by FX volatility.

This is evidence that the excess return is a result of an economically meaningful risk/return relationship. In times of heightened volatility, lower-interest-rate currencies offer insurance, because their exchange rate appreciates in response to an adverse global shock.

Thus, these “safe havens” (such as the Swiss franc) earn a lower risk premium than other currencies that are perceived as riskier. Safe-haven currencies tend to appreciate when market risk and illiquidity increase.

Any Asset Class

4. The study that is perhaps most closely related to the one penned by Lettau, Maggiori and Weber is “Carry,” a November 2013 paper by Ralph Koijen, Tobias Moskowitz, Lasse Pedersen and Evert Vrugt.

They noted that: “While the concept of ‘carry’ has been applied almost exclusively to currencies, it’s a more general phenomenon that can be applied to any asset.” They define carry as the expected return on an asset assuming its price doesn’t change. Stock prices don’t change, currency yields don’t change, bond yields don’t change and spot commodity prices remain unchanged.

Thus, for equities, the carry trade is defined by the dividend yield, a strategy that goes long countries with high dividend yield, and short currencies with low dividend yield. For bonds, it’s determined by the term structure of rates. And for commodities, it’s determined by the roll return, which is the difference between spot rates and future rates. Following is a summary of the authors’ main conclusions:

Conclusions

• A carry trade that goes long high-carry assets and shorts low-carry assets earns significant returns in each asset class with an annualized Sharpe ratio (a measure of risk-adjusted returns) of 0.7, on average. Further, a diversified portfolio of carry strategies across all asset classes earns a Sharpe ratio of 1.1.
• The correlations among carry strategies are low. This substantially reduces the volatility of a diversified portfolio, and mitigates the fat-tail risks that are associated with all carry trades. The result is that while all individual carry strategies have excess kurtosis, a carry strategy diversified across all asset classes has skewness close to zero and thinner tails than a diversified passive exposure to the global market portfolio.
• Despite the high Sharpe ratios, carry strategies are far from riskless—all individual carry strategies have excess kurtosis (fat tails)—and may exhibit sizable declines for extended periods of time. These periods coincide with times (August 1972 to September 1975, March 1980 to June 1982, August 2008 to February 2009) when the state of the global economy is weak; for instance, in recessions and liquidity crises. In other words, carry strategies in almost all asset classes remain positively exposed to global liquidity shocks and negatively exposed to volatility risk. Thus, carry strategies tend to incur losses during times of worsened liquidity and heightened volatility, when stocks do poorly. However, an exception is the carry trade across U.S. Treasurys of different maturities, which has the opposite loadings on liquidity and volatility risks, making it a hedge against the other carry strategies. For investors seeking alternatives to traditional equity and bond strategies, the carry trade is worth considering as long as you understand that the carry premium isn’t a free lunch. It involves the risk of crashes that occur at the same time your equity holdings are likely to be experiencing large losses. Your overall portfolio allocation should take this risk into account.

Larry Swedroe is the director of research for the BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.