TheFinancialWhiz.Com

Back on March 20, 2007, TheFinancialWhiz.Com started an experiment of combining a basket of nine currencies versus the Chinese Yuan (see post). The goal of the basket was to generate positive interest payments from the long currency holdings, with a secondary goal of generating capital appreciation.

The portfolio, as of Saturday, January 5, 2008, has a Net Asset Value of $143,364.22, which represents a 43.36% gain over the initial $100,000 balance. The Net Asset Value is broken down into three components: Initial Investment, Unrealized Gains (Losses), and Interest Income. The below table shows the breakdown of the current portfolio:

Figure 1 provides a better illustration of the percentage of capital appreciation and interest income attributed to the Net Asset Value. Interest Income, the primary goal, represented 61.22% of the gain over the Initial Investment, and Capital Appreciation, the secondary goal, represented 37.32% of the gain over the Initial Investment.

Figure 1.

Over the nine-month test period, the Chinese Yuan Carry Trade Portfolio had a Sharpe Ratio of 1.3696. The inputs used to derive the Sharpe Ratio were a 48.61% annualized return, 5.00% risk-free rate, and a 31.84% annualized standard deviation.

The top performing position in the portfolio was the short USD/TRY (short US Dollar, long Turkish Lira) holding, which along with its superior interest rate, appreciated from 1.40636 to 1.16804, about a 17% gain over the nine-month test period. This 17% increase from capital appreciation was on top of the $5,101 received from interest payments (about 10.20% interest earned on the initial $50,000 position).

Obviously, the worst performer was the long USD/CNY (long US Dollar, short Chinese Yuan) position, which fell depreciated from 7.746 down to 7.2836, or a decline of 5.96%. However, this loss from currency movements is offset by a generous interest rate payment for holding the Chinese Yuan short, since it is a widely known fact that it is being manipulated stronger. After taking into account the interest payments received, the position is down approximately $11,946.13 or 2.38% on the initial $500,000 long USD/CNY position.

A question that has been asked many times is why the Chinese Yuan and not the Japanese Yen, the stereotypical carry trade choice. The answer for them is the fact that the Chinese Yuan is in a controlled appreciation, while the Yen can be very volatile at times. Over the test period if the USD/JPY was substituted for the USD/CNY position, the USD/JPY would have lost approximately 7.05%, but would have been partially offset by an approximate 3.22% positive interest carry, for a net loss of 3.83%. Combine the increase loss with the greater volatility of the Japanese Yen and the Sharpe Ratio drops much lower than that of the Chinese Yuan Carry Trade Basket.

Figure 2 charts the daily Net Asset Value of the Chinese Yuan Carry Trade Basket over the entire test period.

Figure 2.

The chart below shows a breakdown of interest payments per day on the account:

With the account generating approximately $173.166 per day, the portfolio will generate about $63,205.59 in interest per year, which is being generated on a portfolio with a leverage ratio of approximately 5 times the account balance. The leverage ratio is fairly conservative given that retail Forex accounts allow leverage up to 50 times the account balance. The low leverage ratio lowers the risk of a margin call on the currency account.

The results of the Chinese Yuan Carry Trade Basket experiment have been surprisingly positive and while past performance is not indicative of future performance, the generous amount of interest that an investor will receive will offset the majority of downdraws that this diversified portfolio might experience.

Supplemental Charts

USD/CNY - March 20, 2007 - January 5, 2007

USD/JPY - March 20, 2007 - January 5, 2007

USD/TRY - March 20, 2007 - January 5, 2007

Please note that this example is for educational purposes and uses a historical trade from April 2007

Another strategy utilized by investors is the Stock Collar. This strategy involves owning or purchasing 100 shares of a particular stock, buying a put option and selling a call option. An investor sells a call option to finance the “insurance” put option. While doing this does limit the downside, it also limits the upside potential. This strategy tends to be used less by money managers because of the possibility of missing a big positive move.

In Figure 4, the investor purchases 100 shares of Yahoo, Inc. (YHOO) on April 20, 2007, buys the July 2007 $25 put option, and sells the July 2007 $32.50 call option. From the breakdown of the trade in July 2007 at the maximum and minimum extremes, the positions could show a profit of 17.08% or a loss of 9.94%. This type of trade would be most suitable for trading a stock that an investor feels has a good probability of increasing in value, but about which he still holds some hesitations. The idea with this trade is to protect the position against strong negative moves, and instead of paying the put “insurance” premium out of pocket, the investor is simply financing that premium with a call sold for a premium. There are some money managers who use collars when trading indexes; they do this because the likelihood of an index increasing by 3% in a month is very unusual, but a drop of 5% or more is more likely.

A stock/option collar could have been used in the case of Martha Stewart. When she had received insider information that a drug was going to not be approved by the FDA, she then ordered her stockbroker to sell all of her Imclone shares. Although she was not guilty of insider trading, she was guilty of obstruction of justice, after lying to Federal investigators about her actions. Had she known that a news release was about to happen (and had not received the information from the CEO before news release), she could have purchased a collar or protective put to protect against the downside. She would have never run into the problem of selling the stock, had she used one of the options strategies introduced in this paper.

Figure 4

Please note that this example is for educational purposes and uses a historical trade from March 2007

A lesser-known strategy is the Protective Put strategy, which involves purchasing or holding a stock and buying a put option to protect against the downside. The strategy is the opposite of the Covered Call Strategy because the investor is limiting their downside and leaving the upside potential of the position. This type of protection does come at a cost, such as purchasing insurance against a loss; an individual must pay a premium in order to receive the protection. The amount of premium that an investor pays depends on the volatility within the individual stock, the higher the volatility of the stock, the more premium that an investor will have to pay for the “insurance”.

Figure 3 is a fictitious trade involving the purchasing or holding of 100 shares of Google, Inc (GOOG) on March 22, 2007. The reason for this hedge was Google planned to announce earnings after the bell on April 19, 2007, and to hedge against any downside risk the investor purchased a $470 put option, limiting the total risk of loss to $1,750 while maintaining the unlimited upside potential minus the $15.60 put option premium.

Figure 3