Carrying on

Currency traders have endured a hair-raising few months. After weathering much of the volatility in the financial markets in the third and fourth quarters of last year, the foreign exchange markets have been making up for lost time. Having touched 12-year lows against the yen in March, the dollar hit its lowest-ever level against the euro on April 22.

The sharp appreciation of the yen, in particular, represents something of a nightmare scenario for some. Regulators have long warned about the steady build-up of carry trade positions by hedge funds - the majority of which are funded by yen borrowing. A rapid strengthening of the yen, so the theory goes, would cause huge mark-to-market losses for investors with outstanding carry trade exposures, forcing greater numbers to unwind trades - in turn, causing a further spike in the yen and more losses for those hanging grimly on to open positions. In the worst-case scenario, a mass unwinding of carry trade positions could pose a major systemic risk to the financial markets, some regulators have argued.

Certainly, the yen's ascent was rapid, breaching Yen100 to the dollar on March 13 and touching Yen95.76 in intra-day trading on March 17 (see figure 1).

The currency had started the year at Yen111.79, and had been trading at Yen123.94 as recently as June 22, 2007. Nonetheless, the rout many had feared has not materialised.

Certainly, the past few months have not been pretty for hedge funds. Only three of the strategies in the Credit Suisse/Tremont hedge fund index reported positive returns in March - dedicated short bias, equity market-neutral and risk arbitrage. The worst performer year-to-date is convertible arbitrage, which is down 7.64% - although fixed-income arbitrage, emerging markets and long/short equities have also had a tough time, returning -6.78%, -4.2% and -4.1%, respectively. Nonetheless, dealers say many hedge funds had already unwound or hedged carry trade positions, enabling them to weather the worst of the currency moves.

The carry trade involves borrowing in the currency of a country with low interest rates and investing in higher-yielding currencies. Investors are able to make money from the interest rate differential between the two, so long as neither interest rates nor exchange rates move to a sufficient extent to erode the profitability of the trade.

In its most recent annual report, published in June 2007, the Bank for International Settlements identified the yen as a major funding currency for carry trade strategies, a result of the country's low interest rate of 0.5%. The report noted that a steady build-up of carry trade positions had taken place in the year to March 2007, and warned that the unwinding of these trades could contribute to market instability.

"The investors involved are often highly leveraged, and could be forced to unwind positions very quickly in response to changing market conditions. This might have a large impact on exchange rates, especially in smaller markets," the report said.

Indeed, the unwinding of carry trades has been held at least partly responsible for periodic bouts of yen strengthening in May and June 2006, February 2007 and August 2007. For instance, the currency appreciated from Yen121.02 on February 22, 2007 to Yen116.01 on March 5, and jumped from Yen119.74 on August 8 last year to Yen112.14 on August 16.

In both cases, the strengthening followed a shock in the financial markets - in the first instance, a plunge in the Shanghai Stock Exchange composite index and a rise in US subprime mortgage delinquencies, and in the second case, the stepping up of the subprime crisis following the collapse of two Bear Stearns hedge funds, the bail-out of Dusseldorf-based IKB Deutsche Industriebank and the suspension of redemptions on three BNP Paribas funds. This prompted speculation that hedge funds, facing margin calls on loss-making structured credit positions or spooked by increased volatility, had unwound carry trade positions.

Nonetheless, analysts say there are macroeconomic reasons for the most recent surge in the Japanese currency - not least seven rate cuts by the US Federal Reserve since September 2007. The most recent cut, on April 30, reduced the federal funds rate by 25 basis points to 2%.

Certainly, those hedge funds with open yen-funded carry trade positions would be likely to be nursing nasty mark-to-market losses. However, dealers note that many hedge funds have switched to long yen positions over the course of the past year.

Indeed, speculative short yen positions on the Chicago Mercantile Exchange - often seen as an indicator of outstanding carry trade positions - have drastically shrunk over the past 12 months. On April 24, 2007, there were 120,100 short yen contracts outstanding, versus just 32,068 long positions, according to figures from the Commodity Futures Trading Commission. As of April 22 this year, that had fallen to 25,364 short contracts, while long positions had increased to 57,288 contracts.

Christopher Finger, Geneva-based head of research at New York-based risk consulting and software firm RiskMetrics Group, reckons there is now little relationship between the unwinding of carry trades by hedge funds and the movement of the dollar/yen exchange rate. "In the first half of last year, the statistical relationship was at best moderate. Since then, I would speculate they have been unwinding positions on popular carry trades, such as dollar/yen, partly to meet margin calls and partly in anticipation of dollar weakening," he says.

RiskMetrics conducted research last year that questioned the extent to which hedge funds are reliant on yen-funded carry trades (Risk August 2007, pages 30-32). The research found that some hedge fund strategies had a negative correlation to the carry trade, suggesting hedge fund managers were not as reliant on the carry trade as some observers had feared.

In addition, the research described two carry trade strategies - a simple constant maturity strategy and a volatility-based strategy. The latter uses the ratio of interest rate spreads to the implied volatility of exchange rates to determine positions, an approach similar to that used by most hedge funds. As such, an increase in volatility would be likely to prompt users of this strategy to reduce leverage - in other words, hedge funds may well have reduced their exposures ahead of the spike in the yen over the past few months.

Three-month yen implied volatility was at around 8% or less for most of the first half of 2007. This has averaged above 10% so far in 2008, and was at 15% as of April 18. "The yen has traditionally been a popular funding currency, but recently people are buying it back - and that has been a major factor for the currency's volatility," says Chris Leuschke, head of currency structuring at the Royal Bank of Scotland in London. "In the past six months, volatility of exchange rates has increased, making attractive risk versus return carry trades harder to find."

While some funds would have closed out trades, others have used foreign exchange options to hedge short yen exposures. Variance swaps have also increasingly been utilised as a hedge on carry trade positions. These instruments have a payout equal to the difference between the realised variance and a pre-agreed strike level, multiplied by the notional value. The idea is that an unwinding of carry trade positions would probably lead to a rise in yen volatility - meaning those investors with long variance positions would profit, offsetting any losses on outstanding carry trade exposures.

In fact, variance swaps are increasingly being used as cheap portfolio insurance by hedge funds not usually active in the foreign exchange markets. For those investors with foreign currency-denominated equities, for instance, a market shock and mass sell-off would have a knock-on effect on both exchange rates and currency volatility. By using variance swaps on foreign exchange rather than equity variance swaps or index puts, hedge funds can achieve substantial savings on their portfolio insurance, say dealers.

"In the past year, we've seen an increasing number of non-forex hedge funds start using forex derivatives to hedge their portfolio positions. This is particularly true of assets affected by dollar and sterling price movements. These funds now see forex as more of an opportunity, not a risk," says Chris Hansen, head of forex investor sales for Europe at Deutsche Bank in London. "Even prior to July last year, but especially since, we have seen an increase in the use of forex variance swaps by hedge funds, exploiting relationships between equity and forex volatility."

But it's not all about hedging. The increase in currency volatility has also created plenty of trading opportunities - a fact a number of hedge funds have latched on to. "Having static, non-trending exchange rates is the worst scenario for our trading strategy as it makes money on the rise and fall of the rates," says Chris Cruden, chief executive of Switzerland-based investment manager Insch Capital Management.

The firm's Kintillo fund is based on a quantitative analysis of the currency markets, with buy and sell signals generated by price movements and volatility. The fund trades 10 cross-rates, including dollar/euro, dollar/yen and euro/yen, and generated a 7.8% return in March.

"We don't build positions - we open and close diversified, risk-equivalent trades with a short to medium investment horizon, which can last from a few days to a couple of months," says Cruden.

Likewise, Olsen Invest, a Zurich-based hedge fund, uses an algorithm to trade on a short-term basis. Richard Olsen, chief executive of the firm, says he welcomes the recent volatility in the currency markets. "We trade on many small currency movements rather than aiming to profit on larger, long-term views," he says. "We made a profit through the volatile period in March and don't see the ongoing volatility as a threat to our business."

See also:

• Yen rise triggers PRDC hedging

• Cash and carry