In the previous post entitled “Chinese Yuan Carry Trade Basket Experiment,” I described the basic composition of the basket of currencies in that post and this post I have set out to develop a plan to further take advantage of the interest that is received on the currency positions. I looked to a popular stock investment strategy, entitled DRIP (Dividend Reinvestment Plan), takes the dividends that a company pays on its stock reinvests the dividend into that company’s stock. The DRIP strategy runs off of the idea of compounding, where you are receiving dividends, reinvesting those dividends, and then earning dividends off of your initial investment plus the stock which was purchased in the reinvestment plan.
I am proposing using the idea of the DRIP strategy in combination with the carry trade basket so that the interest that is paid on the basket is reinvested equally over the entire basket, instead of different amounts being invested in the specific currency pair that paid the interest. The idea here is that, over the length of your trade, there are going to be some pairs that outperform and some that underperform, and you are indiscriminately reinvesting among all the pairs, so that one year one pair may be the biggest loser and the next year it may outperform. When you are reinvesting in a losing pair, you are slowly lowering your cost basis, while increasing the amount of currency from which you can earn interest.
The Interest Reinvestment Plan would require much upkeep if it was to be done daily, so the proposed strategy described here is a weekly reinvestment. The 37.75% (the current interest rate return as of March 31) in interest received per year would return as such over different compounding periods:
Daily: 45.83%
Weekly: 45.66%
Monthly: 45.01%
Semi-Annually: 41.31%
Annually: 37.75%
I think the best trade off of time and reward is a weekly reinvestment plan, returning approximately 45.66%. This method would also allow you to smooth out the volatility of the basket in the reinvestments. The ability to add approximately $7,910 in return per year on top of the current projected interest rate return of $37,750 makes this type of plan extremely attractive. In addition, the additional interest received from the reinvestment plan will yield approximately $350 in account balance interest over the course of the year (+.35%).
The only downside is that you are keeping your leverage percentage relatively the same, maintaining the strategy at 5x, instead of cutting it down with the interest payments being received over the course of the year. When you reinvest the interest, it is possible that you could lose some of that interest if the currency goes against your position; therefore, if you are solely after the income, you should avoid using this strategy. The use of the Interest Reinvestment Plan is a way to gain more interest through the use of compounding and to smooth out the currencies in the portfolio by reinvesting at different amounts higher and lower than the initial position.
In an upcoming post, I will examine the historical weekly prices of the currency pairs in this basket, and I will apply the Interest Reinvestment Plan over the course of a year to see how it matches up against the original buy and hold strategy.
I have put together a spreadsheet that illustrates how these figures were calculated and the specific amounts used to develop the interest payments. If you have any questions please send an email to bryan@thefinancialwhiz.com or post a comment below.
