Carry Trade Secrets Revealed: Hedging the risk

Make no mistake…the carry trade makes money. In fact, returns on the carry trade can exceed 10% - 60%+ annually. Unfortunately, for 95%+ of individual investors, the funds that use the carry trade to generate returns can’t market to the public and the minimum investment can exceed $500K - $1 million+. Consequently, those privileged enough to participate in the carry trade tend to be high net worth investors, hedge funds, home offices, feeder funds, institutions and/or corporations.

Until now.

Recent technological advances in trading platforms have opened this highly profitable trade to individual investors. The ability to move 100’s of millions in SMAs (Separately Managed Accounts), automatically rebalance accounts, set margin limits, and get fills from multiple liquidity providers has all but eliminated the need for a “fund” structure. What does this mean? It means that individual investors can now actively participate in these returns and profit from the carry trade with opening account balances as low as $50,000.

What exactly is the carry trade?

The carry trade can be defined as borrowing in one currency that has a low interest rate to buy another currency that has a higher interest rate. In doing so, the money manager can capture the difference between the two interest rates. With zero leverage applied, the trade will yield the spread between the two currencies. With, for example, 5 times leverage applied, the trade yields the spread times 5. If the currency is paying 3.5% interest, the trade yields roughly 17.5%. If more leverage is used, the math is the same. The carry trade is one of the most powerful investment strategies investors can now employ.

What you should know.

There are 3 parties involved in the carry trade: the investor, the money manager, and the liquidity provider. All three must have their needs met in order for the trade to function smoothly. The investor is looking for good returns. The manager is looking for fees, and the liquidity providers are looking for fees and flows. The investor pays fees to the money manager and provides the flows to the liquidity provider via their initial investment deposit. The money manager provides the trading expertise. The liquidity provider provides access to the Forex markets and liquidity to execute the trade.

Returns on the carry trade can exceed 10-60%+ depending on interest rates and the amount of leverage utilized. More leverage means an increase in the currency or market risks. However, lower levels of leverage decrease the underlying currency risk and can still produce impressive double digit returns.

Where’s the risk in the carry trade?

The transaction risk lies in the interest rates and, to the extent that interest rates fluctuate, may negatively affect or perhaps enhance the carry. However, interest rate fluctuations have a greater impact in the decision process associated with whether or not the carry is worth the risk that comes with the increased leverage needed to generate returns on a low yielding currency. When global interest rates rise, the carry trade will produce higher returns. If global interest rates continue to decline, the carry would require additional leverage and therefore, run the risk of amplifying the currency risk.

The currency or market risk lies in the volatility of the underlying currency pair. When performing the carry trade, a manager is, in effect, shorting the currency he is borrowing and long the currency he is buying. He nets the interest on the long position and pays the interest on the short position. If the underlying currency on the long side goes down in value, he loses money on that side of the trade. Conversely, if the underlying currency on the short side gains value, he loses money. You can quickly see why the currency risk poses the greatest threat to a successful carry. One needs to eliminate the currency risk altogether, leaving only global interest rates to monitor.

Volumes have been written on hedging the carry trade. Most involve complicated options strategies (exotics vs. vanilla options, etc.), currency futures or buying some form of “insurance” on the carry. The average investor is simply not skilled enough to structure a successful carry trade scenario.

What if the money manager could not simply hedge the currency risk, but rather eliminate the underlying currency risk altogether? If successful, that manager would have an ideal carry scenario with no risk to principal. Does such a trade exist? Indeed it does.

Below is an example of a trade that eliminates the currency risk and, in the current interest rate environment, yields approximately 10% - 17%+ depending on the interest rate on the operable currency pair. Minimal leverage is used in order to keep all parties involved satisfied.

How it works. Eliminating the currency risk. Pure alpha.

The trade.

(The following is not a “directional” trade. The trade eliminates currency risk leaving only global interest rates to monitor. Additionally, this trade gives up all potential gains on the long and short sides of the trade and simply seeks to mimic a “fixed income” strategy. Gains are based on the prevailing interest rate of the operable currency pair(s).)

Two accounts are set up and offsetting positions are then executed simultaneously.
The first account holds a long position in the highest yielding of the G20 currencies against the lowest yielding of the G20 currencies. This account generates rollover swap interest credits from the long position.

The second account is routed through a Sharia-compliant liquidity pool, and holds a short position equal to the first account. The purpose of this account is to hedge or eliminate any currency risk. (Under Sharia Law, the body of Islamic religious law, making money from money, such as charging interest, is considered usury and is therefore not permitted.)
Why it works.

The two trades effectively offset each other, so the “account equity” maintains a constant zero balance as gains on one side are offset with losses on the other. The long side however collects the carry spread and the short side is a “free hedge” given the nature of the Sharia liquidity.

Technically speaking, the trade itself makes no money. The money, in this particular strategy is made via the Tomorrow Next Day Rule.

What is the Tomorrow Next Day Rule?

In most currency trades, delivery is two days after the transaction date. Tomorrow-next trades arise because most currency traders are speculators and have no intention of taking delivery of the currency (similar to rolling a futures contract). If a trader buys and closes out his or her currency position the same business day, there isn’t a problem with delivery. But traders who wish to hold their position over the current business day and have no intention of accepting delivery of the currency would use tomorrow-next procedures: the position is closed out that business day at a closing rate, and then the position is re-established the following day. This allows the trader to hold the position for that day without worrying about delivery. The Tomorrow-next trades rule plays in integral role in the operation of the currency markets allowing traders to rollover positions on a continuous basis.

When a currency trader is long a position, as he holds his positions day after day, he earns interest on his longs in the form of “rollover swap credits.” The value of these swap credits are derived from the prevailing interest rate on the operable currency pair and the amount of leverage utilized.

Managing the Carry Trade.

Eliminating the currency or market risk is the key to a successful carry. The above strategy simplifies the carry trade for all parties and presently provides a principal protected carry with a 10%+ annual return. When interest rates rise, the above trade will simply return more. If interest rates were to drop, the above trade would make less, however, modestly increasing the amount of leverage will help maintain the returns. (Marc Trimble)

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