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

Almost daily, I receive emails asking how a trader can profit from the Turkish Lira, many of whom are drawn to the high interest rate feature of the currency. It is easy to forget about the huge volatile moves that has plagued the currency since its re-release. To look for a safe hedge currency, I examined the available currencies of surrounding countries with economies that in the same development phase. The logical choice would have been a bordering country, but since there are few choices that offer enough liquidity, the closest country was Hungary.

Examining the following calculations of volatility and correlation, the two currencies appear to provide the necessary hedge that will allow traders to profit and at the same time sleep comfortable at night.

The correlation between the two pairs EUR/TRY and EUR/HUF was .87591 during the three-month period of August 1, 2007 to October 31, 2007. This is a significant positive correlation because the market was extremely volatile during the August carry trade unwinding. The fact that the two pairs exhibit a strong, positive correlation means that a trader can go short the EUR/TRY and long the EUR/HUF, and the movement of the two currency pairs, which hopefully will continue exhibiting a strong correlation, will move inversely.

The historic volatility is also significantly lowered when the hedge is in place. Over the volatile August carry trade unwind period, the TRY/HUF pair had an annual volatility calculation of 16.6552%, while the USD/TRY pair had a calculated annual volatility of 25.2925%. While not all times are as volatile as was experienced in August, looking at the August and September period combined, the volatility is still lower in the TRY/HUF pair than the USD/TRY pair, at 13.5576% and 17.6828% respectively.

There is a trade-off to hedging the Turkish Lira with the Hungarian Forint and that is the amount of interest paid on the hedge. With a long Turkish Lira, an investor is receiving 15.75% in interest per year, while with a short position in the Hungarian Forint will cost an investor 8% in interest payments per year, netting the investor a positive 7.75% interest rate spread.

The lower interest received from placing this hedge may not be to the liking of some investors, but the fact remains that the pair will be less affected by a potential carry trade unwind. It appears that the Turkish Lira at this time is ready for a short, sharp depreciation versus the Euro and US Dollar, as it has been treading water over the past three months. However, other emerging currencies can match up with the Turkish Lira and provide a decent hedge, but none can match the Hungarian Forint in terms of similar economic conditions, strong correlation, and an excellent positive interest rate spread.

Disclosure: The author currently holds a synthetic long TRY/HUF position (short EUR/TRY, long EUR/HUF)

Supplemental Charts and Spreadsheet:

Volatility Spreadsheet Download

August 1, 2007 – October 31, 2007 – TRY/HUF

August 1, 2007 – October 31, 2007 – USD/TRY

August 1, 2007 – October 31, 2007 – EUR/TRY

August 1, 2007 – October 31, 2007 – EUR/HUF

This is an update on the performance of the Chinese Yuan Carry Trade Basket. The experiment was started with a base of $100,000 on March 20, 2007. I have included the performance figures for both of the experiments that I have been running, although they are the same in composition, I have leveraged them differently.

Since Inception (5 times leveraged basket):

Increase (decrease) in Account Balance: $27,338.01
Increase (decrease) in Unrealized Gains: $20,811.01
Increase (decrease) in Net Asset Value: $48,148.52
Total Portfolio Value: $148,148.52 +48.15%

Since Inception (10 times leveraged basket):

Increase (decrease) in Account Balance: $54,675.02
Increase (decrease) in Unrealized Gains: $41,622.02
Increase (decrease) in Net Asset Value: $96,297.04
Total Portfolio Value: $196,297.04 +96.29%

As an update, each currency pair in this basket, minus the USD/CNY pair is showing an unrealized profit. The 10x leveraged currency basket yields about $347.41 in interest per day, representing about 126.8% in interest per year on the initial $100,000 investment. The increase in interest is due to the change in the Oanda interest rate for the USD/CNY pair, which currently pays 8.9% in interest for holding the pair long, which should be more than enough to pay for the risk of holding long a depreciating pair.

At this time, I am contemplating rebalancing the portfolio at the end of the year to bring the initial allocations back in line and taking profits on some positions that have moved very favorably over the past 8 1/2 months.

Sorry for the sparse updates about this portfolio in particular, but in two weeks, I should be able to devote more time to presenting and updating the strategies on this site.

This is an update on the performance of the Chinese Yuan Carry Trade Basket. The experiment was started with a base of $100,000 on March 20, 2007. I have included the performance figures for both of the experiments that I have been running, although they are the same in composition, I have leveraged them differently.

Since Inception (5 times leveraged basket):

Increase (decrease) in Account Balance: $11,019.70
Increase (decrease) in Unrealized Gains: $23,221.74
Increase (decrease) in Net Asset Value: $34,241.44
Total Portfolio Value: $134,241.44 +34.24%

Since Inception (10 times leveraged basket):

Increase (decrease) in Account Balance: $22,039.40
Increase (decrease) in Unrealized Gains: $46,443.47
Increase (decrease) in Net Asset Value: $68,482.87
Total Portfolio Value: $168,482.87 +68.48% +55.87%

In 17 days since the last update, the portfolio has increased by 12.61%, which has been due to the continued weakness in the US Dollar versus all major currencies.

This is an update on the performance of the Chinese Yuan Carry Trade Basket. The experiment was started with a base of $100,000 on March 20, 2007. I have included the performance figures for both of the experiments that I have been running, although they are the same in composition, I have leveraged them differently.

Since Inception (5 times leveraged basket):

Increase (decrease) in Account Balance: $9,569.53
Increase (decrease) in Unrealized Gains: $18,364.90
Increase (decrease) in Net Asset Value: $27,934.43
Total Portfolio Value: $127,934.43 +27.93%

Since Inception (10 times leveraged basket):

Increase (decrease) in Account Balance: $19,139.05
Increase (decrease) in Unrealized Gains: $36,729.80
Increase (decrease) in Net Asset Value: $55,868.85
Total Portfolio Value: $155,868.85 +55.87%

The Chinese Yuan Carry Trade Basket has been traded for over three months and has given an investor an annualized return of 97.09% and 194.20% respectively. While past performance is not necessarily a good predictor of future performance, the basket has provided consistent returns in an otherwise volatile currency markets. While the goal of the basket is not to generate unrealized gains, the positive unrealized gain has provided a nice cushion for the investor to extract value from the positive currency movement.
Please check back for further updates at a later time. I would appreciate any suggestions on improving the strategy.

Technorati Tags: Chinese Yuan, Currency, FOREX, USD, GBP, EUR, TRY, Trading, Investing

When trading FOREX, investors usually have major currency pairs at their disposal, but if they wish to trade in some of the exotic currency pairs, their options are somewhat limited. The problem that traders face most often is that these exotic currencies are paired up against either the US Dollar or the Euro; therefore, if someone wishes to trade the Mexican Peso against the Japanese Yen, he would be out of luck. Nevertheless, this trade is possible—it just requires a little extra work on the trader’s behalf.

In the above example of using the Mexican Peso and the Japanese Yen, a trader could accomplish the desired trade by tying the USD/JPY and the USD/MXN together. The idea in doing this would be to have the zero USD exposure, giving the trader the synthetic MXN/JPY pair. For instance if a trader wanted to go long $5,000 worth of Mexican Pesos against the Japanese Yen, he would need to go short 5,000 units of the USD/MXN (short USD/long MXN), giving them a $5,000 short exposure to US Dollars and a long exposure of $5,000 worth of Mexican Pesos. Then, to create the Japanese Yen aspect of the trade, the trader must then go long $5,000 worth of USD/JPY pair (long USD/short JPY). Combining these two pairs together, the trader has created the MXN/JPY pair, because the USD positions cancel each other out.

The next problem faced when creating synthetic currency pairs is the ability to chart the created pair. Although the amateur investor usually lacks access to affordable software programs that would chart synthetic pairs intraday with technical analysis, Google Finance offers a satisfactory alternative. Their site gives small retail traders the ability to chart any synthetic pair over particular time periods (1 month, 3 month, 6 month, YTD, 1 year, 5 year, and a custom time frame). Although the Google Finance option is extremely limited, it does give traders an idea as to the performance of a particular pair over a period. For instance, to chart the MXN/JPY pair on Google Finance, please visit: http://finance.google.com/finance?q=MXNJPY.

While creating synthetic pairs may appear simple, the next problem that a trader will come across is when a trade is in the format of XYZ/USD, where XYZ is a particular currency. In this format, the currency XYZ defines the number of units being purchased. For example, if XYZ is the Euro, then a trader investing $100,000 would be buying approximately 75,188 units of EUR (depending on the exchange rate, I am using the 1.33 and rounding to the nearest whole number). Furthermore, if XYZ is the Australian dollar, then a trader looking to invest $100,000 would be purchasing 119,047 units of AUD currently trading at .87. Currencies commonly formatted like this include the Euro (EUR), the British pound (GBP), the Australian dollar (AUD), and the New Zealand dollar (NZD).

When creating a pair with a currency like those mentioned above, a trader must remember the difference in how he goes about purchasing the units through his broker. For example, a trader may wish to create the EUR/ZAR pair (ZAR is the South African Rand), but the only way to accomplish such a trade through his broker would be to pair EUR/USD and USD/ZAR. At first glance, a trader may think that it is exactly like the above example with the MXN/JPY pair, but since the USD is now purchased in terms of EUR (at today’s price of 1.33), it would take $1.33 USD to buy 1 EUR. As discussed, purchasing 75,188 units of EUR/USD would create the $100,000 USD exposure. The number of units depends on the exchange rate of the currency at the time of purchase; to figure out how much of the EUR/USD to buy the trader would take the total USD amount of $100,000 and divide by the current EUR/USD rate of 1.33. This would mean that the trader would have to buy approximately 75,188 units (note: this is not an exact number, it will most likely be a decimal, there might be a small exposure to the USD) of the EUR/USD to get $100,000 in USD exposure. Then the trader would go long 100,000 units of the USD/ZAR pair (similar to that of the above example using USD/JPY), which would effectively cancel out the USD exposure, now giving the trader a synthetic long EUR/ZAR trade.

One of the problems with creating synthetic currency pairs is that they tie up double the amount of margin as would be required if the exact pair was offered through the broker. This also means that the trader must pay the spread on both of the pairs that he will use in creating the synthetic pair. This is not necessarily a problem, because if the pair was offered directly through the broker interface, it would most likely have a similar spread cost. The only disadvantage is the leverage factor, but this is a moot fact, because any intelligent investor would not utilize more than 10 times leverage in trading currencies, even though many of these brokers offer up to 100 times on trades.

Synthetic currency pairs can be difficult to create, but the ability to understand their composition will open many more trading opportunities to traders.

If you have any questions about the creation of synthetic currency pairs, please do not hesitate to contact me via the comment feature below this post or by email at bryan@thefinancialwhiz.com.

Technorati Tags: Forex, Currency, Trading

Here is an update on the performance of the Chinese Yuan Carry Trade Basket. The experiment was started with a base of $100,000 on March 20, 2007.

Since Inception:

Increase (decrease) in Account Balance: $7,379.42
Increase (decrease) in Unrealized Gains: $12,751.94
Increase (decrease) in Net Asset Value: $20,131.36
Total Portfolio Value: $120,131.36 +20.13%

Although the Chinese Yuan has been gaining considerable strength over the past three months, declining about 1.31%, my belief is that the currency will tread water for now.  The quick decline was due to political pressure placed on China to appreciate the Yuan.  I have also been running the Chinese Yuan Carry Trade Basket at double the size of the positions as was presented in the original post.  The performance of that fund is just two times the above performance figures.  Please check back for further updates at a later time.  I would appreciate any suggestions on improving the strategy.

Here is an update on the performance of the Chinese Yuan Carry Trade Basket. The experiment was started with a base of $100,000 on March 20, 2007.

Since Inception:

Increase (decrease) in Account Balance: $2,646.52
Increase (decrease) in Unrealized Gains: $9,830.41
Increase (decrease) in Net Asset Value: $12,476.93
Total Portfolio Value: $112,476.93 +12.48%

Since Last Update on April 7, 2007 (One Week):
Increase (decrease) in Account Balance: $791.08
Increase (decrease) in Unrealized Gains:$3,830.41
Increase (decrease) in Net Asset Value: $4,621.49

The basket has been the beneficiary of deteriorating fundamentals of the US Dollar. All the positions in the basket are in profit, except for the the USD/CNY positions, which is our carry trade borrowing currency. Please check back for further updates at a later time. Please post any questions you may have.

The success of this basket so far is exceeding my initial expectations. I have uploaded a spreadsheet of the account transactions, including interest payments, available for download if you wish to inspect the results. While the overall sentiment over the past few weeks (since March 20, 2007) has been bearish the dollar, I still feel that this basket can still continue similar returns in any currency environment. I am a bit disappointed with Oanda for increasing the interest rate at which an investor can borrow at in Chinese Yuan (Previously it was -1%; now it has increased to .5% for a total increase of 1.5%), but we can make due with what we have.

The results after two weeks:
Total Increase (Decrease) in Account Balance: $1,855.44
Total Increase (Decrease) in Unrealized Gains: ~$6,000.00
Total Increase (Decrease) in Net Asset Value: $7,855.44, or a 7.86% Return in Two Weeks

The 7.86% return in two weeks represents an annual return of 204.36% without compounding. Now the timing of the decision to create this basket was optimal as seen by the large increase in Unrealized Gains, but the long-term stability of the basket will be the driving factor to continued success. The way to look at this is to say if the basket showed an unrealized loss of $6,000, instead of a $6,000 unrealized gain, you would really only be down 4% when you take into account the interest that you have received. Additionally, that unrealized loss—barring any further negative movement—would continue to be cut by the interest that you are receiving daily from the basket.
The attractiveness of this basket is that there is little exposure to any one currency and they are weighted equally throughout the portfolio. I feel very confident that the growth of this basket will continue, even through periods when the movement is against our positions. The interest is a constant, reliable factor that will enable us to weather any condition in our portfolio (minus a complete meltdown of all the currencies against the Chinese Yuan, which is the only risk). I have collected historical quotes for each currency pair in this basket and I have started to analyze the historical performance of the basket over the past year.

I thoroughly enjoy my continued research on such a low stress investment strategy that will enable me and other traders to create a reliable portfolio that takes advantage of the global Forex market. Please check back in the future for additional updates on this basket.  I am extremely pleased with the potential displayed so far and I will continue to research it.

This analysis did not take into account taxes.

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.