Investment strategies for volatile markets

GLOBAL INVESTOR 3.07 31
The favorable environment for carry trades over much of the past
year was a prime factor behind the increasing misalignment of
currencies with their fair values (see Figure 3). Generally speaking,
the Swiss franc and the yen have moved further into undervalued
territory, while current levels of high-yielding currencies like sterling
and the dollar-bloc currencies are now at stretched valuations.
In the longer term, currencies tend to mean revert to their fair value,
but this process could take several years. It is therefore not surprising
that currency strategies based on valuations have performed
poorly in this environment because, as explained above, those currencies
that are overvalued for the most part have the highest interest-rate
levels and these currencies have strengthened in a
friendly environment for carry trades (see Table 2). However, we expect
to see a more challenging environment for carry trades going
into next year.
Removing excess global liquidity
Following the equity market crash in 2000 and the downturn in
economic growth at the beginning of the century, central banks
have injected liquidity by lowering interest rates to unprecedented
low levels, for example, the Fed Funds rate at 1% and the SNB
Libor target rate at 0.25%. As global growth started to accelerate
in 2003 and remained robust for the next few years, central banks
began removing excess liquidity with a very foreseeable path for
interest rates. This normalization process, which is ongoing at the
time of writing, has helped reduce volatility in equity markets and
other risky assets, and also underpinned the trend for falling implied
volatilities in FX markets. In the longer run, we do not expect
the current status of wide interest-rate differentials to be sustained.
Central banks in Switzerland and Japan have already started raising
rates, although at a slow pace. This trend of normalization in
the last providers of liquidity will, in our view, continue over the next
12 months, but will probably not be the most important factor in
expecting some pressure on carry trades later in the year.
Higher volatility a risk for carry trades
While the narrowing of interest-rate differentials is a very slow
process and unlikely to be a danger for carry trades, the second
ingredient for measuring the attractiveness of carry trades in terms
of risk-adjusted return, namely implied volatility, is more of a concern.
In our view, the financial environment will be more challenging
for risky assets (equities, carry trades) later in 2007 and into
2008. We expect volatility to increase gradually over the next
12 months, but investors should be prepared for short-term spikes
that could lead to fairly sharp movements in exchange rates.
Figure 4 shows that, already in summer, positioning in the shortterm-oriented
investment community (mostly hedge funds) appeared
stretched. These short-term investors are, in our view, more
likely to reduce positions at a rapid pace when volatility increases
or if they have to reduce risk more generally in their portfolios
due to other factors (widening of credit spreads, higher equity volatility).
This could result in contagion from other asset classes to
FX markets.
But there are also other types of investors investing in carry
trades (retail investors, real money accounts). If, for example, an
investor buys a bond denominated in a foreign currency with a
higher yield and does not hedge the currency risk, this also constitutes
a carry trade. However we think it is unlikely that these investors
will liquidate their holdings of foreign assets immediately due
G10 currencies: The G10 currencies include the US
dollar (USD), euro (EUR), Japanese yen (JPY), British
pound (GBP), Swiss franc (CHF), Australian dollar (AUD),
New Zealand dollar (NZD), Canadian dollar (CAD),
Swedish krona (SEK), and Norwegian krone (NOK).
FX market: The foreign exchange (FX) market is a global
market with 24-hour trading and an average daily
turnover of an estimated USD 1,880 billion, according to
the Bank for International Settlements (BIS).
Forward-rate bias strategy: This simple trading strategy
invests in currencies in the G10 universe. The
strategy involves buying the three currencies with the
highest interest-rate level (3-month LIBOR) and funding
this investment from the three G10 currencies with
the lowest interest rates. In theory, the forward of an
exchange rate should, on average, be an unbiased
predictor of the future spot rate. The longer-term expected
return from a forward-rate bias strategy should
therefore be zero, under the assumption that there is
no risk premium. However, empirical literature has
shown that these returns have been positive in the past,
meaning that the uncovered interest-rate parity does
not hold.
Market participants in the FX market: Corporates,
pension funds, retail investors, hedge funds, commercial
banks and central banks.
Sharpe ratio: The Sharpe ratio measures the return
in volatility units, i.e. characterizing how well the return
of an asset compensates for the risk taken. The riskadjusted
carry (return) on a 3-month horizon is calculated
by dividing the interest-rate differential between
the 3-month money market rates of two currencies
by the implied volatility. This gives an expected return
per unit of volatility.
Hedging: Currency hedging is a strategy to reduce risk
in a portfolio from unfavorable exchange rate movements.
This can be done by forward contracts or options.
Forward contract: A forward contract is an agreement
between two parties to buy or sell a currency pair
at a pre-agreed future point and price (forward price).
The forward price at any point in time is given by the
interest-rate differential between the two currencies
(arbitrage condition).
Option: An option gives the buyer the right, but not
of currency at a strike price at some point in time
(or before expiration).