2008 Vol. 1


Real Estate

Pansy Yang, Ph.D. (Bio)
Executive Director of the Center for Finance & Investments (CFI)

The currency carry trade is a popular investment strategy used to exploit mispricing in foreign exchange markets. Here's how it generally works. Find a country that offers loans yielding a low interest rate. Borrow in that currency, exchange it for the currency of a different country that is offering higher interest rates on investments, invest it in that market and earn the higher interest. A more specific example would be borrowing yen at 0.5%, converting to dollars, and buying U.S. Treasuries yielding 5%. Sound like a pretty good deal? As with anything that sounds too good to be true, the carry trade is not without risks.

For a strategy that should not work in theory due to uncovered interest rate parity, it has had quite a run. In addition to investment banks and hedge funds, household investors including Japanese housewives, regularly mentioned in the popular press, were all playing the carry trade. Until early 2007, it was estimated that as much as US $1 trillion may be staked on the yen carry trade (The Economist, February 1, 2007). However, the subprime crisis starting in the middle of 2007 proved to be the beginning of the carry trade's unwind.

Hanno Lustig, one of our rising stars on the finance faculty at UCLA Anderson, provides this issue's academic perspective. Hanno tests the carry trade in 22 countries, and finds that a risk-adjusted carry trade strategy, levered to match the volatility of the S&P 500, consistently outperforms a buy-and-hold in the US stock market. He also discusses how rising volatility in currency and stock markets adversely affects the performance of the strategy.

Vineer Bhansali, executive vice president portfolio manager at PIMCO, shares his industry insight. Vineer also explores the role of currency volatility in the performance of carry trades. He proposes a solution that mitigates this risk by hedging in the currency options markets, and shows through back-testing that the risk of the carry trade can be lowered.

Please send your comments >>


Hanno Lustig (UCLA) and Adrien Verdelhan (Boston University)

Hanno LustigDr. Hanno Lustig is an assistant professor currently teaching at the UCLA Anderson School of Management. He received his Ph.D. in economics from Stanford, and his M.S. from the Catholic University of Louvain (Belgium) and B.S. from the University Faculties St-Ignatius Antwerp (Belgium). Prior to joining UCLA, Dr. Lustig spent several years on the economics faculty at the University of Chicago. His research interests focus on asset pricing, macroeconomics, exchange rates and international finance. He has given invited seminars at MIT, Harvard, NYU, Northwestern University, amongst other leading schools in the field of economics. His research has been published in top academic journals, including the Journal of Finance, American Economic Review, and the Review of Financial Studies.

Introduction
Low-yield currencies consistently produce low returns and high-yield currencies consistently produce high returns for US investors. This is true for a wide range of currencies in both developed and emerging markets, and it holds true over long periods of time. As a result, the carry trade in currency markets, borrowing in low-yield currencies to go long in high-yield currencies, has been a profitable investment strategy over the last three and a half decades. In fact, a levered position in currency markets has consistently outperformed the US stock market. However, carry trade investors load up on systematic risk. Cross-country differences in interest rates convey information about differences in the risk characteristics of these currencies, much in the same way that differences in book-to-market ratios convey information about stocks.

Read the paper >>




Vineer Bhansali
Managing Director, PIMCO

Vineer BhansaliVineer Bhansali, Ph.D., is a Managing Director, firm-wide head of analytics for portfolio management, and a senior member of PIMCO's portfolio management group. Dr. Bhansali joined PIMCO in 2000, previously having been associated with Credit Suisse First Boston as a vice president in proprietary fixed-income trading. Prior to that, he was a proprietary trader for Salomon Brothers in New York and worked in the global derivatives group at Citibank. He is the author of numerous scientific and financial papers and of the book Pricing and Managing Exotic and Hybrid Options (McGraw Hill, 1998). He currently serves as an associate editor for the International Journal of Theoretical and Applied Finance. Dr. Bhansali has fifteen years of investment experience and holds a bachelor's degree and a master's degree in physics from the California Institute of Technology, and a Ph.D. in theoretical particle physics from Harvard University.

Overview
The currency "carry trade," in which an investor buys assets in a higher yielding currency by borrowing in a lower yielding currency, has been consistently exploited as a source of profits by investors. In this note we explore the risk-return underpinnings of the carry trade and demonstrate that the carry trade is effectively a form of short volatility trade. We also explore a simple strategy that combines carry with options and present a heuristic statistic for the measurement of the economics of the carry trade. We test the strategy on actual historical carry and option price data and find that the hypothetical strategy allows for the presence of arbitrage opportunities between the forex option and carry markets. The recently unfolding crisis in the financial markets has been accompanied with rising volatility and unwinding of the carry trade.

Introduction
The events surrounding the Federal Reserve's FOMC meeting of Dec. 11, 2007 were interesting in many respects. Reflecting on the weakening credit and liquidity conditions that accompanied the subprime debacle of 2007, on that date the Fed cut both the FedFunds target rate and the discount rate by 25 basis points (bp). This was disappointing to market participants who were expecting more, and the stock market immediately sold off, credit spreads widened, the Brazilian Real and other emerging currencies sold off, and the Japanese Yen strengthened close to a percentage point. In addition, volatility rose across markets. Coming into the morning of Dec. 12, all of these moves were reversed as the Fed, ECB and all other Central Banks announced that they would make special liquidity available to alleviate the short-term credit squeeze. The dollar rallied against lower yielding currencies such as the yen. This two day period was consistent with the expected performance of currency pairs in which one currency has a much higher interest rate (the carry currency) than the other currency (the funding currency) during periods of heightened and lowered risk. As recent market movements have shown, when volatility rises, the carry trade suffers, and when volatility falls, the carry trade does well. Can we explain this by leaning on finance principles?

Read the paper >>


Recent

April 4
UCLA hosted a joint conference with neighboring schools USC and UC Irvine for a research packed morning. The aim of the conference is to foster greater communication and research collaboration between the universities. Papers on the program included:

  • "Do Hedge Funds Profit From Mutual-Fund Distress?" by Joseph Chen (USC), Samuel Hanson, Harrison Hong, and Jeremy C. Stein.
  • "Real Interest Rates, Expected Inflation, and Real Estate Returns: A Comparison of the U.S. and Canada" by Richard Roll (UCLA) and Kuntara Pukthuanthong-Le.
  • "When are Outside Directors Effective?" by Ran Duchin (USC), John G. Matsusaka (USC), and Oguzhan Ozbas (USC).
  • "Style Distinctiveness and Hedge Fund Performance" by Ashley Wang (UCI) and Lu Zheng (UCI).

Upcoming

May 16
Join us for an academic perspective on alternative assets. Roberto Rigobon (MIT Sloan) will be discussing the sub-prime contagion and its impact on a global level, and David Scharfstein (Harvard Business School) will talk about the stock market and drug development.


By Mark Hulbert

If you get speeding tickets, watch out: The chances are good that you will also engage in possibly dangerous investing behavior, too. That is the implication of a new study that found that individuals who receive more speeding tickets tend to churn their portfolios.

The study, "Sensation Seeking, Overconfidence and Trading Activity," has been accepted for publication by The Journal of Finance. The authors are Mark S. Grinblatt, a finance professor at the University of California, Los Angeles, and Matti Keloharju, a finance professor at the Helsinki School of Economics. A version is at http://www.anderson.ucla.edu/documents/areas/fac/finance/06-06.pdf.

The professors were able to find a correlation between speeding tickets and trading frequency after receiving access to several data sets of Finnish investors. Though the professors did not have access to the investors' identities, one of these databases contained details of speeding tickets issued between mid-1997 and the end of 2001 to residents of Helsinki and surrounding areas. Another had information on the portfolios and trading records of all Finnish households from 1995 through 2002. The Finnish government also provided data on the incomes, age, marital status, gender, occupation and homeownership status of all those filing tax returns in 1998 and 1999.

These rich data sets enabled the professors to eliminate from consideration other possible causes of trading activity and focus on the distinct influence of speeding tickets. They found that, other things being equal, an investor's portfolio turnover rate rose 11 percent after each additional speeding ticket he received. That is a surprisingly strong correlation, and is highly significant from a statistical point of view, according to the professors.

Mark GrinblattIn an interview, Professor Grinblatt acknowledged that the propensity to speed did not remain constant throughout life. As people grow older, they are likely to become more conservative drivers and, not coincidentally, to trade less often. But he stressed that he and his co-researcher controlled for factors like age when conducting their tests. So one way to interpret their findings is that, between two people of the same age, the one who gets a speeding ticket is likely to have 11 percent more turnover in his portfolio.

Why would the tendency to speed be associated with more trading? One possible factor that the professors explored was overconfidence: If a driver deludes himself into thinking that he can avoid being caught when speeding, he may also delude himself into believing he has above-average stock-picking ability.

After studying overconfidence, however, the professors concluded that it was not the source of the link. They had also been granted access to the extensive psychological tests that the Finnish armed forces administered to all men upon their induction into mandatory military service, and overconfidence was one trait these tests carefully measured. The professors found that while overconfident investors tended to trade more, the trait was not correlated with their number of speeding tickets.

(The Finnish authorities devised a way of providing the results of these tests, along with the other sets of data, without divulging anyone's identity, thereby respecting Finland's strict privacy laws.)

The professors' findings about overconfidence, along with results of other complex tests they conducted, led them to conclude that the correlation between speeding tickets and more frequent trading was caused by something quite different: thrill-seeking. They found that thrill seekers -- those who look for a new and risky experience just for the fun of it -- trade more often not because they have an inflated belief that they can beat the market, but because they find a static portfolio too boring.

DID the thrill seekers nevertheless improve their returns by trading often? No, the professors found. They found that the stocks bought by the thrill seekers fared no better, on average, than those they sold.

If anything, Professor Grinblatt said, the thrill seekers were worse off, after considering transaction costs. They "cannot justify their trading in terms of their performance," he concluded.

The study provides yet more evidence that psychological motivations play a large role in investment decisions. The implication is that, before we initiate any trade, it's wise to engage in some honest self-reflection about our motivations. Are we trading because there is compelling evidence supporting it, or simply because we find our long-held stocks aren't exciting enough?

Undoubtedly, all of us would benefit from periodically asking ourselves this question, but Professor Grinblatt said that it was especially important to ask it after we've been pulled over for speeding.


LOS ANGELES -- UCLA Anderson School of Management announced today the launch of its highly anticipated Master's of Financial Engineering (MFE) program, designed to serve students seeking advanced business education with a focus on quantitative finance. The one year program provides a depth of study in finance that is more quantitatively oriented than in traditional MBA programs, while also emphasizing the development of key leadership skills.

"Organizations today operate in global financial markets that are experiencing explosive changes and fluctuations," says Judy D. Olian, dean of UCLA Anderson School of Management. "Consequently, the level of financial and technical savvy required by firms has accelerated the demand for superbly-trained financial engineers."

While MFE programs are available at other universities, UCLA Anderson is one of the few elite business schools to offer the MFE degree. Taught by a world-renowned finance faculty, the UCLA Anderson MFE program affords an innovative curriculum that combines theory, analytics and application in a variety of areas, ranging from venture capital and risk management, to more technical operations such as securities design and quantitative trading. UCLA Anderson is also home to the Center for Finance and Investment (CFI), a research and education center that focuses on investment management, corporate finance and financial engineering. The Center will provide valuable learning opportunities to MFE students as well as unique collaborative opportunities with industry partners.

Bob mark"Our MFE program will provide students with a world-class academic experience that integrates a technically challenging curriculum with practical know-how," says Dr. Robert Mark, executive director of the UCLA Anderson MFE Program. "Program graduates will not only be thoroughly equipped to face the complex demands of the market, but will also be well-trained to manage and lead in organizations."

Situated in Los Angeles, a global center for investment management, the UCLA Anderson MFE program enjoys strong industry ties offering students many opportunities to interact with leaders in the local and international finance community. The MFE program places a strong emphasis on students' career preparation and carefully monitors the development of each student throughout his or her year of study. UCLA Anderson MFE students also have access to a wide-reaching network of alumni, faculty, and professionals in the global finance community to help support students' internship and job search goals.

For more information, please visit: http://mfe.anderson.ucla.edu


Amit Bhatia (MBA '08)

Students with Warren BuffettEvery year, the 15 member Anderson Student Asset Management (ASAM) fund receives an invitation to visit Warren Buffett. This year we were lucky to get more invitations, which we in turn opened up to the larger student body. It was a defining experience for all of us who were there. We arrived on a Friday morning at a building in the middle of Omaha that showed no signs of being the Berkshire Hathaway Global Headquarters.

UCLA Anderson was one of three schools in attendance in a small auditorium along with Creighton University and a school from Brazil. At 10:00 am, the Oracle himself arrived and answered our questions for the next two hours. With great humility and remarkable clarity, he outlined his investment philosophy, his views on the markets, on wealth and on life itself in response to our many questions. After that, he invited four students, two from UCLA and two from Brazil to sit in his well used Lincoln Towncar, which he drove himself to the Piccolo Pete's, one of the restaurants owned by Berkshire, where he was treating us to a Nebraskan feast. The rest of us followed in our bus, and as 80 students walked through the folksy diner in Omaha wearing full suits, patrons gave us knowing looks that seemed to imply, "Warren's hosting students again." (He hosts students 12 times a year, which are some of the few social engagements to which he agrees).

After a hearty lunch of salads, steaks and root beer floats, we him and he proceeded to take individual snaps with every single one of the hundred students present. Many snaps later, he bid us farewell as we thanked him for hosting us so graciously, and he proceeded back to the public parking lot where he had parked his car, and drove away. What stood out during the whole trip wasn't just his intellect and the clarity with which he saw the markets, but the liberating freedom and simplicity with which he lives his life that allows him to make astute investment decisions free from the greed, vanity and fear that are the downfall of most investors.

Some excerpts from his speech:
On investing: "Two years ago I was flipping through this book on Korean stocks, and I found this stock that trades at twice its earnings with a lot of cash on its balance sheet. I wait for such opportunities."

"Being a successful investor is about being able to take a pass and only swing at the pitches you want to swing at."

On managing crisis: "On one Sunday while I was in my pajamas playing bridge on the Internet, I got a call regarding Long Term Capital Management. All the good deals get done on Sundays."

On the Internet: "The Internet changed my life. I play bridge online 12 hours a week."

On being wealthy: "When I was young, I wanted to own my own golf course and a boat. I then realized that they don't make me happy ..." " ... I was at Bill Gates' birthday party hosted by Paul Allen on his big boat. There were seven couples on the boat and a crew of 55. If you have 55 employees, you can be sure that one guy is stealing from you and two people are hooking up when they shouldn't be. I don't want that kind of stress. It's better to have friends with boats."

On being a public figure: "Sometimes I show bad judgment. I was on CNBC and said that when I do a good deal, it's orgasmic. I should have known that they'd play that in all their advertisements."

On staying happy: "I don't accept social commitments. I meet students 12 times a year because I like that, but I don't accept things that I don't enjoy."

Amit Bhatia is a full time Anderson MBA student graduating in June 2008. He will be working for Morgan Stanley as an Associate in Investment Banking in their Los Angeles office upon graduation.

Center for Finance & Investments
UCLA Anderson School of Management
110 Westwood Plaza, Los Angeles, CA 90095