New York: A doubling in currency volatility since June has knocked the “carry trade” off its perch as the most profitable strategy in foreign exchange, hurting investors from John W Henry & Co. to Campbell & Co.
In carry trade, you borrow and pay interest to purchase financial investments that have higher interest, such as long-term bonds.
In one of the more popular carry trades, a US investor, who borrowed in yen to buy high-yielding Australian dollars, enjoyed a return of 11% this year through 5 June, data compiled by Bloomberg shows. The gains have since been wiped out. Chalk up another victim to the spreading US subprime mortgage contagion.
The fallout from losses on loans made to people with poor credit is spreading so fast that investors are selling any asset smacking of high-risk around the globe, causing wide swings in exchange rates that weren’t anticipated.
New York-based JPMorgan Chase & Co.’s volatility index on options for the most-traded currencies reached 13.4% last week—the highest since 1999.
“We were caught off guard,” said Terri Becks, president and chief operating officer of Towson, Maryland-based Campbell.
“When these anomalies in the market happen, in this case how highly correlated moves in many markets were, you are either on the right side or the wrong side. This time we were definitely on the wrong side”, in currencies, interest rates and equities, he said.
Campbell’s biggest fund, with $9 billion (Rs37,440 crore) in assets, lost 10.8% in July—the most since 1990. John W Henry’s $122 million financial and metals portfolio fell 11.7% in July—its worst month since March.
Rising currency volatility is bad news for investors in the carry trade because it increases the risk that gains from interest rate differentials will be erased by foreign exchange losses.
The JPMorgan volatility index fell the past two years, reaching a record low of 5.76% on 8 June.
John W Henry’s loss
In currencies, Boca Raton, Florida-based Henry’s largest loss in July was in the yen, Kenneth Webster, president and chief operating officer of the alternate asset management company, said in a statement on its website.
Assets at the firm, which are owned by John W. Henry, who also controls the Boston Red Sox baseball team, have plummeted by 75% since November to $479 million.
“The turmoil in the credit markets had a collateral effect on the currency markets as investors bought back short positions in low-yielding currencies,” Webster wrote. He declined to comment beyond the statement on the website.
A short position is where an investor has trades set up that would profit from a decline in the value of a currency. Investors, who hoped for a rebound in the carry trade this month, are likely disappointed.
The Australian dollar has lost 15% since it reached 107.74 yen on 20 July—the highest since 1991, as investors sold the currency and bought back yen. That helped push Japan’s currency to a 14-month high of 111.61 against the US dollar on 17 August.
“I don’t think that the unwind of the carry trade is over by a long shot,” said Naomi Fink, senior currency strategist at BNP Paribas SA in New York.
“The subprime issues remain.”
Rising delinquencies on subprime mortgages forced two hedge funds managed by New York-based investment bank Bear, Stearns & Co. Inc.to file for bankruptcy last month, while BNP Paribas in France halted withdrawals from three funds because it couldn’t “fairly” value their holdings.
The Federal Reserve last week cut the rate it charges banks by half a percentage point to 5.75% in an attempt to avert a credit crunch and restore investor confidence.
“The herd is stampeding, and somewhere it will stop,” said Harry Markowitz, winner of the Nobel Prize in economics in 1990 and now a finance professor at the Rady School of Management at the University of California, San Diego.
“The news will pass and things will start to settle down again.”
Carry trade dissected
In the carry trade, investors borrow in countries with low interest rates, such as Japan, and invest the proceeds in the currencies of countries such as Australia, New Zealand and South Africa, which have high rates. They profit on the difference.
Overnight lending rates in Japan average 0.55%, compared with 6.5% in Australia and 8.25% in New Zealand.
The carry trade outpaced three other currency strategies through June, returning 2.6% for 2007, data from ABN Amro Holdings NV, the biggest Dutch lender, reveals.
A 2.4% drop in July erased most of the 2007 gain and put it behind a 2% profit for traders focusing on swings in volatility, according to ABN. The two other styles, valuation and trend, both have lost money this year.
“The best of times for the carry trade is in the past,” said Paul Lambert, who manages the Polar Capital Discovery Absolute Return Fund for London-based Polar Capital Holdings Plc., which has $3.8 billion in assets. Lambert’s fund gained 1.3% in July, he said.
Campbell’s Becks cited 26 July as the day that pushed the company to adjust its computer-model-driven strategy, and reduce leverage by 50%. As global stocks fell that day, the yen closed stronger than 120 against the dollar for the first time since May.
Campbell’s financial, metal and energy large portfolio has lost 6.02% this year, for a 13.8% annual return since its 1983 debut.
John W Henry’s financial and metals portfolio is down 11.18% this year—bringing its annual return to 22.6% since it was started in 1984.
“The cost of carry is volatility,” said Peter Jacobson, managing director at London-based Rhicon Currency Management, which oversees $300 million in two open-ended funds and several managed accounts.
“If the spot currency markets move a lot, it’s more difficult to hold on to long carry.”