August 12, 2008

Hanno LustigHanno Lustig, Assistant Professor of Finance at UCLA Anderson, and colleagues Nick Roussanov of Wharton and Adrien Verdelhan of Boston University have been exploring one of the most striking recent phenomena in the world of global investments -- currency trading. Their recent paper, "Common Risk Factors in Currency Markets," provides insight into the risky nature of this widespread practice and suggests why it continues in a volatile global economy.

"Currency trading is a huge thing," says Lustig. Observers estimate that nearly $4 trillion changes hands in currency trades each day.

The basic idea is to use the currency of a country with a low interest rate to buy government bonds in a country with a higher interest rate. "For example," says Lustig, "suppose the interest rate for a one-year European bond denominated in euros is six percent and the rate for a one-year U.S. bond is five percent. You might decide to invest in Europe because it will give a higher return."

But Lustig says economists have expressed doubts. "They say this should not work," he says, "because what will happen is that the euro is going to depreciate by one percent, which will completely offset the effect of the higher interest rate. So, economists have said that it doesn't really matter where you invest -- because changes in the exchange rate will offset the difference in the interest rate."

However, currency trading has been a profitable investment strategy for decades. "It seems to be the case that investors make money by chasing higher interest rates around the world," Lustig says. "So if you look at a whole bunch of countries and buy bonds in the ones with the highest interest rates, you will make money. It seems to be an empirical irregularity."

But Lustig and his colleagues argue that currency trading offers no free lunch. "We have found that investing in high interest rate currencies is risky," he explains. "You are taking on risk that looks like U.S. stock market risk. This seems kind of contradictory if you are investing in these foreign currencies but, in reality, you are taking on more U.S. risk.

"We show that bad news in the stock market causes high interest rate currencies to depreciate dramatically while low interest rate currencies actually appreciate," he continues. "So high interest rate currencies are really risky when there is a lot of volatility and turbulence in financial markets."

How risky? "You could say investing in high interest rate currencies is a little like investing in risky stocks," he says. "A bit like investing in value stocks, for example. We know that you can realize higher returns on average by investing in value stocks, and this seems similar to investing in high interest rate currencies."

So what does that mean for currency traders -- many of which are huge financial institutions? Lustig says this means that traders can continue to pursue this strategy, referred to as the "carry trade," but they should be mindful of potentially serious risk. "If you already hold a lot of equity in your portfolio and then you add this carry trade strategy," he says, "you are exposed to a double risk if the stock market tanks. First, your stocks will fall and then your portfolio will take another hit because you're exposed to this currency risk.

"What currency traders do," he says, "is borrow money in low interest rate currencies such as Japanese yen or Swiss francs and invest it in high interest rate currencies such as Australian dollars, New Zealand dollars or Icelandic kronur. What happens when volatility picks up is that traders 'unwind' their positions. They start selling high interest rate currencies and buying back Japanese yen and Swiss francs."

On days when stock markets drop significantly, currency traders can become trapped by the sudden appreciation of low interest rate currencies. "You can easily lose five or six percent in one day," says Lustig. "And if you are highly levered, you can lose a lot more. In fact, it could wipe you out."

Large institutional currency traders hedge their risk by building portfolios of currencies and participating in high volume markets with relatively narrow bid-ask spreads. "After you account for bid-ask spreads," says Lustig, "we show that the typical carry trade strategy, with no leverage, will give you about five percent per annum, which is similar to what you earn investing in the stock market." Investors with leveraged positions can get returns that consistently exceed the stock market.

According to Lustig, the Sharpe ratio for currency trading, which characterizes how well the return of an asset compensates the investor for the risk taken, is about 50 percent. "This is higher than you get in the stock market," he says, "so it seems to be a very appealing proposition. But, if you dig a little deeper, you notice there's actually quite a bit of risk involved."

Lustig's research shows that interest rate is the single risk factor that can explain the variation across currencies in average excess return. "This is what you want to see," he says. "If you think it's a risk-based story, you want to come up with a factor that can explain the variation across currencies so that if a particular currency is more exposed to this risk, it ought to have a higher average return. It's just basic finance. Similar to what you would do for stocks."

Lustig encourages traders to develop portfolios of currencies based on interest rates. "By diversifying your portfolio," he says, "you average out all the idosyncratic noise in the background and focus on what you're really interested in, which is the relation between currency interest rates and risk."

Read a paper by Hanno Lustig and Adrien Verdelhan on the carry trade as a trading and investment strategy.

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