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Lecture 1 The crisis in the Foreign Exchange MarketForeign exchange market: where currencies are traded internationally
The 2007 financial crisis was truly global, compared to other crises (like 1997 Asian Crisis)
FI: fixed income
FX: foreign exchange
Global financial crisis in the foreign exchange market
- A once in a career event? Look at whether the different waves of the global financial
crisis affected only once the foreign exchange market or gradually.
- Unlike the 1997 Asian crisis, 1998 LTCM & Russian default crisis, or earlier, this crisis was
affecting all markets globally. Europe, Asia, and US
- Tequila crisis—this time it is truly global.
- Focus on FX market: low transparency relative to Fixed Income and equity markets.
- What happened? When? Why?
- Analyze crisis metric and currency market.
What is Carry Trade?
- What defines an exchange market: trading in currencies → carry trade.
- People (e.g. traders) engage in carry trade due to failure of UIP (uncovered interest
parity) or CIP (covered interest parity)
- If UIP and CIP hold, then any gains from interest trade differential will be completely
offset by the expected change in the exchange rate
This implies that there are no gains to trade in currencies internationally. This means whatever
differences you have in the interest rates across countries, you do not engage in trading currencies.
Because any interest rate gain that you might have, is offset by changes or expected changes in
currencies.
- For example: if we have the interest rate of currency A and the interest rate of currency B
and we assume that the interest rate of currency A is higher than the investors are
intended to invest in the currency with the higher interest rate. But, investors expect the
value of this currency to go down in the future (vis a vis, the value of the currency in B)
and in this case any interest rate gain that you might have is offset by the change in the
exchange rate.
- In the case above UIP and CIP holds, and traders do not engage in carry trade. Then any
gains from the interest rate differential will be completely offset by the expected change
in the exchange rate.
If UIP holds, carry trade is not profitable, because it is profit that you make because of the interest
rate differential. You are indifferent when UIP holds.
- Carry trade is defined as follows:
o Imagine a trader having a portfolio of two currencies (say the dollar and the Yen).
Assume that the interest rate on the dollar is lower to that on the Yen. So in this
case the trader will want to buy Yen given that this yields a higher interest rate.
But he will finance his purchase of Yen with his Dollar holdings. In other words,
the trade will go short in the dollar and long in the Yen.
1
, ● short: what you borrow (if assets in Japan offer a low interest rate,
you borrow in Yen)
● long: what you buy / you’re investing in (to convert to pounds, you
use the proceeds to invest in assets in England and go long in the
Pound, because it offers a high interest rate)
o Interest rates of currencies: we’re talking about interest rates of assets.
For example: US treasury bills bear an interest rate. If we say the interest rate on the dollar we mean
for instance the interest rates on us treasury bills.
Carry trade = trading in exchange rate contract, when you want to make benefit out of interest rate
differentials between countries. Borrow money from low interest rate countries, use the proceeds to
convert to different currencies and you invest in the assets in a country that has a currency that
explores a higher interest rate.
How can we borrow the money?
● Issue corporate bonds or shares (buying Yen, going short) 1%
● Convert our Yen to Pound
● We will lend the Pounds to a government or corporation that offers the asset with high
interest rate (going long) 5%
● After the investment expires, we earn the pounds back + the interest rate.
● We now have to pay off our borrowed Yen, profits: 5% - 1%
The Crisis Begins . . . . . . August 2007
- FX was the last to join the party. There were other markets that were impacted by the
global financial crisis.
o Aug 16, 2007 it begins...major carry unwind (in carry trade)
o The first “5 standard deviation event”.
● This means that the expected volatility in the market of movements in
currencies increased by 5% points, which means that uncertainty in FX
markets increased substantially. When uncertainty increases, this means that
traders are reluctant to take part in carry trade (trading currencies
internationally)
- Typical carry trade: short JPY (very low interest rates), long NZD, AUD, GBP. . .
o Aug 16, 2007 AUD/JPY falls 7.7% (avg daily change of 0.7% YTD, this drop was
massive) → traders started to liquidate / tried to sell their positions in the AUS
dollar, because they go long for the AUS dollar because of the high interest rates
vis-a-vis JPY
o Deutsche Bank Carry Index: Consist of a portfolio where the investors are going
long in the 3 highest rate currencies and short in 3 lowest rate currencies.
2
,The index shows the evolution of carry trade. When this index goes down this means that there is
liquidation in the FX market (the carry trade goes down, high uncertainty in the market).
In the figure there are events in the global financial market that took place. These events are
associated with the carry trade index. There are different events, such as the Sep ‘08 moment, when
carry trade collapsed (investors were unwilling to engage in currency trading).
Key message: events that impacted financial markets other than the FX market, had a major impact
on carry trade / FX market. After for example the Aug ‘07 event, it recovered, the uncertainty was
removed, and the volume of carry trade went up again until Nov ‘07 when it went down again.
Key message: FX markets are highly impacted by events in other asset markets (corporate bonds,
stocks, asset back securities, bonds issued by emerging markets, assets other than currencies)
A drop in this index, is a drop in the volume of investments.If the index drops, there is more
uncertainty, and the volume goes down. There is an increase again, because the US government and
federal reserve intervened and risk appetite restored again.
3
, What Caused The Carry Unwind?
- Losses in equity & fixed income portfolios causing deleveraging
→ People started liquidating their positions in fixed income portfolios. Typically fixed
income portfolios are long term portfolios; that involve long-term bonds issued by
governments or by corporations. The liquidations of these portfolio’s and thereby
the deleveraging caused uncertainty on the market and these arrived finally in the FX
market that led to the carry trade unwind.
- Risk appetite fell
- Looked like typical carry unwind as risk-taking returned later in August ‘07 and carry
rebound was seen
There was a drop in carry trade, because of the deleveraging in fixed income
portfolios. But then uncertainty was restored in the markets (by government
help), so carry trade went back to normal due to the removal of risk in the
market.
- Implied volatility of AUD/JPY tells a similar story to DB Carry Index.
o Normal vol of 8% rose to 28% but promptly fell as the market moved back to
“normality”.
o Implied volatility = market forecast of a likely movement in a securities price. So
the implied volatility in the AUD/JPY exchange rate is what markets expect the
volatility of that specific exchange rate to be in the near future. If markets
become risk averse and uncertain, there is a high probability that the volatility of
that exchange rate will go up. If this is the case then the reluctant to engage in
carry trade that involves this specific exchange rate.
Aug ‘07 events increased the implied volatility, but then uncertainty was restored in markets, you see
that the expected volatility of the Exchange Rate went down → increased risk appetite → increased
volume of carry trade.
4
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