Innovation in foreign exchange: algorithmic strategies become more popular

Investors' need for stable returns in difficult equity and bond markets remains high in 2010. As well as "safe haven" investments like gold, new trading strategies based on carry-trades have lately become a focus of interest.

UBS E-News for Banks, January 2010

keywords: Foreign Exchange, Carry Trades, Innovation, Structured products, Algorithmic trading

Executive Summary

  • The recent dislocations in financial markets have increased investor interest in currency transactions through carry trades.

  • Traditional carry trades offer attractive returns to a large extent independent of traditional asset classes, and are transparent and easy to understand. They tend to hit their limits, however, in phases of risk aversion and high volatility.

  • Combining carry trades with algorithmic trading programs offers significant advantages.

The global crisis in financial markets has at least one good side to it: there has hardly been a period in history when so many enlightened investors have had such an exact understanding of the interconnections between global markets, the influence of central bank interest rate and monetary policy on the economy, and global macroeconomic interdependencies. The negative development of the greenback last year forced even US investors to think about alternative currencies and to look for more stable sources of earnings. For this reason, the term "foreign exchange" is making a comeback in many investors' vocabularies. In Europe as well, more and more private investors are recognizing that, alongside traditional asset classes like equities and bonds, there are other interesting alternatives, such as for example currencies.

Carry Trade - the classic in the currency business
Carry trades have dominated currency market activities over the last several years. A currency carry trade is a long (asset) position in a high interest currency which is financed by a short (liability) position in a low interest currency. In a carry trade, the investor tries to exploit the interest rate differential between two currencies. If for example an investor takes out a loan in Japanese yen at 0.4%, he or she can turn around and invest it in Australian dollars for 4.6% and pocket the difference of 4.2%. This asset-liability position is not without its risks, however. If exchange rates move in favor of the low interest currency, then the interest rate differential will come under pressure both from appreciating liabilities and depreciating assets, which can lead to large losses. In our example, if during the lifetime of the loan the yen rises more than 4.6% against the AUD, the investor would be faced with a loss.

Theoretically, this kind of operation should really be a zero-sum game, as one would expect the Australian dollar to fall in value over the duration of the investment until it reaches the AUD/JPY forward price. In other words: the higher interest earned on the investment in Australian dollars should theoretically be lost again by the investor through the exchange rate. In the case of AUD/JPY, however, the expected devaluation of the Australian dollar over the last few years has not materialized. Quite the contrary, the AUD has actually risen against the yen. In this case the investor profited twice: once from the higher interest of the high-interest currency, and once from currency appreciation over the duration of the investment - which just goes to show that theory rarely provides a good picture of actual practice.

In times of insecurity and high volatility, however, this strategy doesn't work. Investors become more risk averse, which tends to lead to flight to "safe haven" currencies like the Swiss franc, the Japanese yen or the US dollar. This generally leads to a strong devaluation of high interest-rate currencies like the Australian dollar. For the carry trade investor such a situation means a greater risk of loss if he or she doesn't reduce his or her position in the high-interest rate currency in favor of a position in a low-interest rate or "safe haven" currency in time.

A carry strategy is more than a carry position
To avoid such losses, an investor would be wise to follow a strategy that allows for the closing of the liquidity position as soon as it moves to the disadvantage of the investor. In some cases it can even be advantageous to reverse course and take an asset position in the low-interest currency which is financed by means of an expensive loan in the high-interest currency. We would classify this as a typical "anti-carry" situation. One very promising strategy, therefore, involves adroitly switching between carry positions, neutral positions and anti-carry positions. Such a strategy can be implemented either on a case by case basis by the investor or investment manager, or through program trading.