After writing about the viability of a carry trade involving the Chinese Yuan, I got to thinking about how I could develop a basket of currencies to create a diversified carry basket involving a number of major and exotic currency pairs. This basket would seek to profit from the low volatility of the Chinese Yuan and from the large interest rate spread received for holding the USD/CNY.
In my previous post in regard to using the Chinese Yuan as a short, I illustrated the interest rate spreads with ten different currencies; I have taken those ten currencies and equally invested them against the Chinese Yuan.
The basket is currently set up to make approximately 38.05% in interest a year, at the current interest rates. At first glance the strategy may appear to be risky, but this basket is only leveraged at 5 times the balance. The asset allocations for the basket are below with unit values and approximate USD values. As you can see from the $100,000 basket, I am short $500,000 worth of Chinese Yuan and long $50,000 USD worth of each currency against the Yuan. This basket appears to be 10 times leveraged, but since these are creating synthetic currency pairs in reality it is really 5 times.
Below are the positions that are being held in the account:
L USD/CNY - 500,000 units
S USD/CAD - 50,000 units
S USD/TRY - 50,000 units
S USD/ZAR - 50,000 units
S USD/INR - 50,000 units
S USD/MXN - 50,000 units
L NZD/USD - 71,000 units
L AUD/USD - 62,500 units
L EUR/USD - 37,554 units
L GBP/USD - 25,492 units
I ran a test taking into account the performance of this basket over the previous year and came out with a return of 29.60%, which includes the interest payments and the currency movements. While the interest rates paid a return of 38.05%, the currency pairs had a negative return of 8.45%, which added up to the 29.60% overall return. Furthermore, this basket is diversified among different areas of the world, so it is unlikely that problems in one area will affect other currencies in the basket. The laggards over the previous year were the South African Rand (ZAR) and the Mexican Peso (MXN), while the rest of the portfolio performed well and made up the losses that were realized from the previous two investments. I ran the test as if the returns were opposite, such that the gains in the GBP, EUR, AUD, and NZD were switched to negative. After running the opposite test, I still came out with a positive return of 21.99%, which gives this portfolio a low volatility due to the positive interest gained from mostly the long USD/CNY position, which pays a daily interest amount of $81.16. The overall portfolio basket pays a positive interest gain of $104.25 a day on a $100,000 account.
Although interest rates change constantly throughout the year, I do not expect them to deviate greatly from the current levels unless there is a huge macroeconomic shock. I also realize that the past year’s analysis does not take into account the different interest rates, but instead applies the current interest rates as if they were stable throughout the year.
I will continue to map the performance of this basket over the next few weeks and months, but so far I see a lot of potential in this type of trade because of its diversification among a number of uncorrelated pairs and its limit of US Dollar exposure.
The biggest problem with a currency basket is when you start to see large unrealized gains; the psychology of a trader will make them more likely to cash in on those profitable positions. While it is always good to lock in profits, traders should stick to their specific strategy and not deviate from it. However, I am currently brainstorming an efficient method to profit from unrealized gains (losses) in the Chinese Yuan currency basket, although the main strategy that relies on the interest earned and the appreciation (depreciation) is secondary.
The weights in the currency basket can also be adjusted if you aren’t comfortable with leveraging your account by a multiple of 5. You can still earn 19.05% in interest a year by just leveraging your account balance by a factor of 2 ½ times. This carry basket can be easily adjusted for your risk tolerance, but please perform your own due diligence should you choose to look further into the potential for this strategy. The tools mentioned in the previous post would be helpful in examining possible investment combinations for your own currency basket.
This carry basket strategy is ideal for the part-time investor that is looking to supplement an overall investment portfolio with an asset class that is relatively uncorrelated to the domestic and international equity markets.
Please post your questions or comments or feel free to email me at bryan@thefinancialwhiz.com with specific questions. This analysis does not take into account taxes or spread costs.
