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Chapter 26, Part I. Let's Start with Carry. - Q&A

Discussion in 'Complete Trading Education- Forex Military School' started by Administrator, Feb 8, 2012.

  1. Administrator

    Administrator Just Administrator :-)

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    Please use this thread for questions, answers, and comments on this lesson.
     
  2. papao

    papao Private, 1st Class

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    Hi Commander and thank you for that lesson. I'd like to ask you some question.

    1) according to Interest rate parity theory (in particular, the uncovered version), returns on domestic and foreign assets should be equal. This because the high yielding currency is expected to depreciate in order to balance the net return. The assumptions of the theory are strong and compelling, the theory seems to be correct so the carry trade shouldn't yield higher returns. From that perspective, higher returns on carry trade should be justified by the exchange rate risk. I know, we are traders and we don't take care of what should happen (like Efficient-market hypothesis, random walk etc.). But i'm curious: why the carry trade works? :) I mean, why the high-yielding currency tend to appreciate? In fact, the covered interest rate parity theory seems to be very accurate (we can clearly see different quotes on spot and future market, even with tiny interest rate differentials).
    2) however, a carry trade is a risky trade (like any other trade), and the amount of interest collected by the trade could be easily wiped out by a small movement of the market (in terms of pips). So, i was wondering if it was possible covering the position using options, in order to gain "risk free" leveraged interest. (For example, if we go long on AUD/USD, we can cover the risk buying a put. Paying the premium we are assured that if the market goes down, we gain interests, and if the market goes up we can also profit from the appreciation of the currency). Probably this is not possible (probably the premium is higher than the interests). And what about making a syntethic short position with options? (Let's say we are again long on AUD/USD. We can hedge that positino making a synthetic short position, buying a put and selling a call. In this case we couldn't profit from an appreciation of the high yielding currency, but the price would be lower (the cost of the put option minus the price of the call option)).

    Thank you in advance!
     
  3. Sive Morten

    Sive Morten Special Consultant to the FPA

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    Hi Papao,
    nice questions.
    I'm shame a bit, but I didn't hear about "Interest rate parity theory". I've heard about prescious metal (monetary theory) that better money push worse money - gold vs. silver for instance, or gold vs paper money.
    Although I didn't think much about what you've said, but it sounds curious. For instance, Australia has AAA rating and 4.5% rate on its currency, while US has AA rating 0.25% rate and much worse fundamental ratios - deficit, debt burden, budget earnings/interest, M3 money supply and others. The reasonable question - why AUD should depreciate to USD? I see some nonsense in the statement that all curencies have to give the same return. Since USD now is more risky - it depreciate to AUD. And that is logical, because investors demand more USD for every AUD.
    I can find the foundation for your theory only may be in inflation term, but I'm not sure. Here is make sense to take a look at real returns instead of nominal. In this case, may be, carry will be not so significant.
    It works, because you may borrow Yens or USD for 0.25%, convert them in AUD and buy AAA gov. bonds for 4.5-6%. That's why it works. The most risk here is to make reverse transaction in time. It also depends on your major account currency. Also carry suggests low leverage or even abscense of it.

    You can't hedge this neither by futures nor by options. Because if you will take a look at math - you'll see that currency options include rate differential for the term of option. So it price already includes this difference for term till expiration.
    The same is with futures. It includes rate difference.
    One thing that is possible somehow here is to create some structural product. For example, if you borrow money in USD, convert them and buy some AUD bonds - you may use some part of coupon income to buy USD/AUD options. This will reduce your overall income but you will be hedged against unwelcome AUD depreciation. But this is just an idea.
     
  4. papao

    papao Private, 1st Class

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    Thank you Sive for your quick answer.

    no, i think this is a quite different theory :)

    The interest rate parity theory is one (out of many) theory that tries to explain movements on exchange rates. I studied it in Macroeconomics (Oliver Blanchard, 4th edition). This is a quite simple theory. If we have similar assets (domestic and foreign, similar in riskiness and liquidity), and we can choose in which invest (or, we can move our capital in and out our country) we will choose the higher yielding asset. And this is obvious, both for local and foreign investors. So all investors should buy only the high yielding asset. (in order to buy the higher yielding asset they need to change their currency (they buy it in the spot market, and this lead to an appreciation of the spot rate), they buy the high yielding asset (and his price will increase, so his net return will decrease). Now they might either cover their position selling the revenue of the investment on the future/forward currency market (depreciating the future exchange rate. This is the covered version of the theory) OR they might wait the end of the investment and sell at that time the revenue of the investment (this is the uncovered version of the theory)). Anyway, this is a condition of non-arbitrage, and we can see it in action every time a central bank increase or decrease his rates surprising markets (money flows almost instantaneously on the higher yielding currency, and this keeps the net returns of investment in equilibrium).
    (may be you can read a better explaination of the theory in wikipedia: Interest rate parity - Wikipedia, the free encyclopedia ).

    may be this isn't the right question (the exchange rate that we will have in the future should remain at his mid-long term level of equilibrium. It's the current, the spot rate, that is higher due to the mechanics explained by the theory).


    ok, i understood it. Of course, different risks justifies different returns. I posted my question because i'm always surprised seeing again and again how "strange" are markets (they are strange because they didn't always follow theories), and because i read on different books something about the carry trade (most of times they talk about it as a risk free trade, and it can't be!). Now i see we agree that is a risky trade (because of the risk in closing position and because the leverage (and the leverage makes it attractive, but implies additional risk)).

    ok, it would be too good for being true :D (and, i think, this is an effect (or a confirmation) to the covered interest rate parity (we can't get a risk free higher yielding)).

    As usual, thank you Sive for your kindness!
     
  5. dkami

    dkami Sergeant

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    Hi Sive Thanks for this lesson as I have been waiting for a carry trade lesson to hopefully pick up some more tips;)
    This is all I do to get great 50++% returns even with my low leverage system I use with little more than 5min work a day,Swap + pip profit its really a no brainer:D
    Got to love the AUD/JPY and am a proud Aussie:D
    Looking forward to reading part 2
    Thanks again Sive for sharing
     
  6. Pharaoh

    Pharaoh Colonel

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    Personally, I'm annoyed that kangaroo currency is doing so well against the USD in the long run, but do enjoy the swap interest. :p

    What really ticks me off how most brokers find this as an easy way to steal more money from traders. I don't expect positive swap on a pair to be exactly equal to negative swap, but I've seen cases where the negative swap on a pair was 4 or 5 times larger than the positive swap and also cases where swap was negative in both directions. :mad:
     
  7. Sive Morten

    Sive Morten Special Consultant to the FPA

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    Right. This is extremely important notice on OTC Forex market. I totally agree that understanding of swap calculation with particular broker is must, especially if you are planning to rely on swap as a part of your total income.
    From that perspective trading futures on AUD/USD is much safer - here is no voluntarism in swap calculation ;)
     
  8. Aldo Colombo

    Aldo Colombo Corporal

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    I´m interested in basic theory, I couldn't find what you refer to as "better money push worse money", why would gold be better than silver or paper money?
     
  9. Sive Morten

    Sive Morten Special Consultant to the FPA

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    Hi Aldo, just because it is worthy and has greater value. I suggest you to read classical monetary theories.
    Just imagine that you're some producer of some goods. You will be offered to pay for your goods either with gold, silver or paper money. What you will choose?
     

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