TheFinancialWhiz.Com

Hi Bryan,

What do you think of this combo?

L USD/CNY
S USD/TRY
L EUR/JPY
S EUR?TRY

Does this spread risk evenly while maintaining high interest?

Joel

Joel,

I am not sure about the spreading of risk because you are making a sure bet on the Turkish Lira increasing in value through this combination. While you are able to receive a lot more interest through this combination, you are opening yourself up to some risk, especially if the Japanese Yen starts to increase, since it is trading at multi-year highs against the Euro. This may possibly translate into losses in the TRY/JPY trade.

With all of the talk about the unwinding of the Yen Carry trade, I just feel that it is a risky carry trade borrowing currency right now.

Although, I do not suggest to trade this way in my strategy, your combination can be a viable strategy if the risk is managed. As long as you do not leverage this trade too much, you will probably be alright. Perhaps you might want to ease into the trade, instead of purchasing all at once. You may be able to get a better price should there be a big correction in the Japanese Yen.

What are your allocation plans for this combination basket in terms of leverage?

Bryan

just curious - you said that the only way this could go wrong would be:

“a complete meltdown of all the currencies against the Chinese Yuan, which is the only risk”

But it seems clear that the Chinese Yuan is indeed appreciating rather steadily (at around 3% / yr or so) against exactly such a basket. What magnitude of Yuan appreciation would be necessary to offset the gains made by the interest?

Paul,

The basket of currencies is yielding approximately 7.50% in interest per year per leverage factor. This means that the Chinese Yuan would need to appreciate by about 7.50% against all the currencies in this basket. Since the basket is well-diversified among a number of different regions in the world, the likelihood that the Yuan will appreciate by that factor is small.

The Chinese have little incentive to allow their currency to appreciate too much because that would mean that their exports would cost more to the rest of the world. In a previous post, I mentioned that the Chinese will probably continue to allow the Yuan to appreciate by the US inflation rate (approximately 3%).

You may come across articles from some experts that are predicting a 10% step appreciation of the Chinese Yuan overnight, I do not see this as a viable option. The fact is that if overnight all goods exported from China cost 10% more, American consumers would change their spending habits and flock to other products. This would effectively stall the growth that China is experiencing and would have massive negative consequences for both countries. Plus, negativity in economic outlooks in both the US and China would mean that countries that have less exposure to China would experience an appreciation in their currencies (Thus, the basket would most likely not experience the full downside potential).

And even if the Chinese Yuan does appreciate by 10% overnight, the basket would continue to generate the carry interest (which represents approximately 7.50% a year). In other words, in the unlikely event that China would do something so drastic, the portfolio would have “limited” downside of ~2.50% (7.50% interest - 10% Yuan appreciation).

Bryan

Where did you come up with this 7.5% apr per leverage factor? According to Oanda’s currency interest rate calculator, they are currently giving the CNY a borrowing rate of .75% which could be invested in USD which is quoted at 4.925%, yielding a net interest differential of 4.125%

And this is only on the Yuan trade as well which makes up only about 1/2 of the total portfolio. A weighted average of the other interest differentials (the dollar and other currency crosses) yields about 2%.

So on the outlay of $950,000 you could expect to make about 3% from interest, but you are exposed to a lot of currency fluctuations here - leveraged close to 10:1.

I think if you look at the substantial gains that you have made in the past several weeks from this portfolio you will see they come from a smart play on dollar weakness (currency movements) and not really from the carry trade (interest).

I agree with a lot of your analysis, and have made a spreadsheet which I think paints a much more reasonable picture of the type of returns you could expect from this portfolio. I really like this concept and I think it is probably often overlooked (especially trading the yuan which is very difficult to do - i didn’t know you could do so with Oanda).

I will email the spreadsheet to you - let me know what you think. Great idea nonetheless.

I didn’t have my updated spreadsheet at my disposal tonight (on my thumb drive), but I did put the figures into a new spreadsheet and found that the adjusted interest rate for the basket is 5.98% per leverage factor. The lower rate is due to Oanda raising the interest rate on the Chinese Yuan borrowing rate. The lower APR for the basket does make this strategy a little less attractive, but the stability of the Chinese Yuan makes it a far better carry candidate than the volatile Japanese Yen or Swiss Franc. I am currently in the process of testing a sidecar basket that is diversified with a position in some lower interest currencies/commodities such as the Japanese Yen, Singapore Dollars, and Gold/Silver. The goal of this second basket is to give up some interest in order lower the volatility of the overall portfolio.

I consider the portfolio to be leveraged at five times because the positions are synthetic, even though in actuality the account is holding 10 times the account balance in positions.

I would very much agree that the weak dollar has been the main reason for the strong initial returns. But it is interesting to note that the interest paid on the positions has accounted for roughly 25% of that total return.

I greatly appreciate your comments, because with any idea there are always points that are sometimes overlooked by the creator. Once the semester is over on Wednesday, I plan on backtesting both of the baskets going back to when China decided to partially remove the USD peg (I do not have software to backtest, so I have to manually calculate these figures using a spreadsheet, very time consuming).

Bryan