The Magnitude, Causes, and Duration of Currency Carry Unwinds
The article "When Carry Goes Bad: The Magnitude, Causes, and Duration of Currency Carry Unwinds" by Duncan Shand and Michael Melvin defines carry trade as a speculative scheme involving the purchase of currencies from countries with high interest rates and the sale of currencies from countries with low interest rates in order to generate positive returns. According to the principle of interest rate uniformity, exchange rates fluctuate to offset interest rate differentials between currencies; thus, such trades should not yield a profit. Despite the fact that carry trades provide positive returns due to investor irrationality and market inefficiency, some research demonstrate that the returns of currency carry trading imply a risk premium. Despite the fact that carry trades' return distribution has considerable negative skewness, many people do not know about the in-depth experience of the drawdowns of currency carry trades. Therefore, the article catalogs the major losses that have been experienced in currency carry trades in the recent times and pinpoints the factors that are likely to have contributed to these losses.
Developing a Duration Analysis
Developing a duration analysis can help portfolio managers to realize the drawdowns of currency carry trades and decide whether to quit from their positions or stay. An understanding of the drawdowns is essential in evaluating whether it is necessary to cut positions immediately they set in, assuming that they will carry on for a while. It can also help to determine whether it is essential to hold on to positions, considering that the drawdowns will reverse after a short while and asset prices will improve. In spite of the fact that each event is different, it is worthwhile to be cognizant of the systematic effects that the exploration of a duration analysis could uncover.
Currency Investors and Marking to Market
Currency investors are usually "marked to market" every day to work out the portfolio's day-to-day returns. Despite the fact that the present forward positions are not closed out every day, investors calculate returns to the positions using forward points and spot exchange rates to deduce a current forward rate. They then interpolate this rate to the existing forward contract's settlement date. This computation determines a suitable level of the existing forward rate to compare with the current forward rate to establish the loss or gain upon the closure of the position. Monthly interest rates that are used to determine the daily returns are helpful in the calculation of the forward points too. Investors use excess returns instead of log excess returns to calculate portfolio drawdown returns.
Data and Portfolios Used
The data which the article has used includes a spot as well as one-month forward exchange rates from the WM/Reuters rates that were sampled in London at 4:00 p.m. The article's focus is on the currencies which active traders widely trade. It uses portfolios constructed by ordering the currencies in the realm of investment based on interest rates. This construction involved ranking currencies in descending order based on the interest differentials vs. the US dollar. Besides, the grouping of currencies into portfolios can be arbitrary or by trading the top three currencies vs. the bottom three. In every case, the strategy involves funding the long positions in the currencies that have high-interest rates with the short positions in the currencies having low-interest rates.
The Performance and Drawdowns of Carry Trades
Shand and Melvin constructed the portfolio using data collected from developed markets between December 1983 and August 2013 and data obtained from emerging markets between February 1997 and August 2013. The data sampled in the emerging markets reflects the illiquidity which has existed historically and the absence of flexible rates of exchange. The construction of portfolios also involves the addition of the currencies from developed markets to those from emerging markets. The results include all currencies, sampled figures from the developing markets, and data from emerging markets. The outcome of the study shows that the performance of currency carry trade was excellent, with a few setbacks only. However, the moment a financial crisis set in, the drawdowns became more frequent and more extensive. An analysis of the drawbacks' magnitude and duration shows that they have been heterogeneous to a certain extent.
Differences Between Developing and Emerging Markets
Some differences are notable from a comparison between the carry returns of developing markets and the carry returns of emerging markets. The latter outperformed the former during the overlap period. Besides, the financial crisis appears to be a developed market-oriented event wherein the currencies of the developed markets had a more severe drawdown than the emerging markets' currencies. Indeed, it is possible to notice the importance of the choice of currency since currency carry trade returns may differ substantively. Since 1997, when the return series for emerging markets began, the correlation between developed markets and emerging markets has simply been 0.26. One can also notice that one commonality between the two markets is that the performance of carry trades has been challenging for their currencies since the onset of the financial crisis. Undoubtedly, the convergence of interest rates which occurred during that time lowered the carry trades' opportunity set temporarily.
Drawdowns in Carry Trades
In spite of carry trades having offered positive returns in due course, it is undoubted that they are subject to significant drawdowns' tail risk. Carry trade portfolios have long-run excess returns that are positive; however, there are episodic incidents of severely adverse returns. An examination of the drawdowns for developing markets portfolio reveals that the most severe drawdown was associated with the financial crisis witnessed between 2007 and 2009 and the most extended drawdown occurred between 1992 and 1995 during the ERM crisis of Europe. An analysis of the emerging markets portfolio shows that the most prolonged drawdown occurred between 2011 and 2013, trailing the financial crisis. Some of the currencies which have been the primary contributors to drawdowns in developing markets include the New Zealand and Australian dollars, Swiss franc, and Japanese yen. Conversely, some of the leading contributors to the emerging markets drawdowns include the Brazilian real, Turkish lira, South African rand, and Indonesian rupiah.
Challenges and Duration of Drawdowns
The general inference that traders purchase low-interest-rate currencies and sell high-interest-rate currencies does not apply at all times, more so in the case of currencies in emerging markets. In some incidences, the low-interest-rate currencies of emerging markets which traders commonly use as funding currencies tend to depreciate against the US dollar since traders often sell them across the board when markets are experiencing financial strain. In such circumstances, the carry trade's short side works to mitigate the drawdown's size. Even though the period of drawdowns is significant to investors, it has not received adequate attention. The article sets forth that supposing drawdowns have lasted till today, they are less likely to come to an end tomorrow. They are more likely to persist. Nonetheless, the duration in which they exist changes systematically.
Determinants of Drawdown Duration
Shand and Melvin put forward that three variables are associated with the duration which the drawdowns of currency carry trades last. The first variable is a financial stress index which is useful in measuring economic conditions that vary with time. The second one is currency carry trade opportunity which is the difference between the average of the interest rates on the carry portfolio's long currencies and the average of the interest rates of the carry portfolio's short currencies. The third variable is a measure of valuation of spot exchange. These variables are essential factors which determine the duration of the drawdown. It is possible to use them to condition the position of currency carry trades to minimize the losses that arise due to carry sell-offs. The researchers examine these duration determining factors as conditioning variables for minimizing risk when they give a sign of longer durations of drawdown and provide an implementable strategy to diminish the carry trade exposures when the contributing factors issue a warning sign of a more extended period of loss. The determinants improve the measures of tail risk as well as the risk-attuned returns. They also give an outline on how to use these variables to come up with estimates of a drawdown's probability of carrying on for a given period. These estimated possibilities can be helpful to inform a portfolio manager's decision concerning the time in which a carry drawdown may last. The estimates can also help the managers to decide whether to lessen exposures or not.
Analyzing Duration Models
The article shows that it is possible to analyze duration models in terms of "survivor functions" to measure the probability of a carry trade drawdown lasting for a given period. An evaluation of this model's estimates at the explanatory variables' mean values produces a survivor function whose values include 0.09 for 100 days, 0.43 for 30 days, and 0.85 for five days. Given the mean values of the duration determining factors at the drawdown's onset, the estimated probability that a drawdown would last 30 days is 43%. When a portfolio manager experiences a carry drawdown, the primary challenge is to decide whether to cling to a position hoping that the loss would reverse in a little while and that the position would again yield positive returns. They also face the challenge of deciding whether to cut carry exposures bearing in mind that the drawdown would carry on and that it is prudent to minimize exposure to more losses.
Conclusion
In conclusion, this article evaluates the most severe awful occurrences of currency carry trade drawdowns in the recent decades, including causes, duration, timing, and attribution by currency. It estimates a model of length or drawdown to explore the factors that determine the duration of losses. It discovers that the period changes steadily with three issues. The first one is the anticipated return on the carry trade after the drawdown has commenced. The second one is financial stress indicators, while the final issue is the scale of deviances from a value portfolio of the portfolio holdings related to currency carry trade. The article shows that the factors which determine the duration of a carry loss determinants can be helpful to control losses and improve the performance of investments.
Works Cited
Shand, Duncan and Michael Melvin. "When Carry Goes Bad: The Magnitude, Causes, and Duration of Currency Carry Unwinds." Financial Analysts Journal 73.1 (2017): 121-140.
