What money managers miss in currency carry trades

FINANCE

A common trading strategy is the currency carry trade — borrowing in the currency of a country with a low interest rate and using the funds to invest in the currency of another nation with a higher interest rate, then profiting from the difference. For example, one popular carry trade is borrowing funds in Japanese yen and investing it in the Australian dollar.

A research paper, ‘Commodity Trade and the Carry Trade: A Tale of Two Countries,’ looks into the phenomenon that commodity exporters such as Australia and New Zealand, tend to have high interest rates compared to importers of basic goods such as Japan and Switzerland that also export finished products.

Wharton finance professor Nikolai Roussanov recently spoke to Knowledge@Wharton about the findings of the paper, including why he thinks money managers who do both commodity and currency carry trades could be overloading on risk. He co-wrote the paper with Robert Ready, assistant finance professor at the University of Rochester, and Colin Ward, assistant finance professor at the University of Minnesota. The research received the 2016 prize for best paper from Wharton’s Jacobs Levy Equity Management Center.

An edited transcript of the conversation follows.

Knowledge@Wharton: Tell us about your paper.

Nikolai Roussanov: I work in the area of international finance, international asset pricing, which tries to understand the determinants of security prices in global financial markets. That includes exchange rates — determination of currency prices — as well as interest rates and other relevant financial variables.

One of the big puzzling questions in this area of research relates to what is known as a carry trade strategy in international financial markets or currency markets, which basically says that if you invest in a high-interest rate country’s currency or high-yielding currency, and you finance that investment by borrowing in a low-interest rate currency, on average you make money. You earn a positive return even though it’s not risk-free. You’re exposed to risk because of the currency fluctuations. On average, though, fluctuations don’t wash out the difference in interest rates. This is known as a carry trade strategy because it carries this interest rate differential. This is a very well known fact, and many people have worked on it including myself.

In this paper, we try to look at the determinants of this carry trade strategy and its profitability. We do that by looking at specific countries or currencies involved. If we think of a typical carry trade strategy, say, the Australia dollar or New Zealand dollar, which are typical high-interest bearing currencies, and short Japanese yen or Swiss franc — borrowing in countries where interest rates are historically very low. To some extent, these days that would include the Eurozone also.

“[Currency] trading strategies … are potentially much more closely intertwined with investments in other asset classes, in particular commodities, than is commonly realized.”

Now, what differentiates these countries fundamentally is the fact that they have very different structures for their production and international trade, or imports and exports. Australia and New Zealand are primarily exporters of basic commodities like iron ore or natural gas, whereas the historically low-interest rate countries, such as Switzerland or Japan, are typically exporters of sophisticated manufactured goods. Think of Japan with cars or Switzerland with watches or pharmaceuticals. And they typically import the bulk of their commodities.

We asked the question, does this difference in fundamentals of the countries’ economies help explain the difference in their interest rates historically? Also, this interest rate differential is associated with what we would call a risk premium, meaning a compensation for bearing the risk that shows up as an average return earned by investors who are exposed to this risk.

What we found both theoretically and empirically is that there is a reason to think that these commodity currencies — the currencies of countries with high-interest rates — would be more risky to an investor in global financial markets than currencies of a commodity of importers and exporters of manufactured goods such as Japan and Switzerland. Basically, the idea is pretty straightforward because we know the commodity countries’ currencies move with the prices of commodities those countries export. That’s why they’re often referred to as commodity currencies. It’s not surprising that the Australia dollar or New Zealand dollar would go up when commodity prices go up, and go down when commodity prices go down.

If we think about the global economy and the global economic cycle, commodity prices globally will go up in times of global expansion, like we experienced in the early 2000s. And they massively fall during global economic downturns, as we saw during the Great Recession and the global financial crisis. That would make those currencies particular risky.

We also see that currencies of sophisticated manufactured goods producers, such as Japan or Switzerland, actually appreciate in downturns. They act as a hedge against the global bad economic conditions. That tells you that it’s not surprising to expect a risk premium that would be earned by investors who are willing to bear this risk of investing in very cyclical commodity currencies, such as Australia and New Zealand, as opposed to the sort of insurance or safe haven currencies of, say, Japan or Switzerland. That, in a nutshell, is our explanation for why we see this historically observed carry trade risk premium or carry trade profitability when we’re looking at this range of countries.

Knowledge@Wharton: What are some practical implications of your findings?

Roussanov: The key implications for the practice of asset management or global macro-investing is recognizing that trading strategies in foreign exchange and currency markets are potentially much more closely intertwined with investments in other asset classes, in particular commodities, than is commonly realized. It’s not deeply ingrained in the philosophy of many investment managers to integrate asset classes as opposed to treating them in isolation. What our research shows is that at least when we’re talking about these sort of global macro-strategies of investing in currencies around the globe, we have to realize that exploiting, for example, the carry trade will carry along with it an exposure to the global cycle and in particular to the commodity price cycle.

Commodities have become a popular asset class of their own over the last decade or so, and there’s great interest in investing in commodities. But a portfolio that is exploiting the carry trade on one hand and also trying to have exposure to commodities could be overexposed to the risk that is contained in both of these on the face of different asset classes and different strategies. One has to be careful not to overload on that kind of global commodity risk.

“It’s not deeply ingrained in the philosophy of many investment managers to integrate asset classes as opposed to treating them in isolation.”

Knowledge@Wharton: What sets your research apart from other work in this area?

Roussanov: There are several ways in which we’re quite different from what has been done. I think we are the first, or certainly some of the first, to recognize that when we model countries in the global financial markets, we have to recognize that these countries are potentially quite different. Most of the research historically that aims to understand risk premium in global financial markets or exchange rates typically looks at two countries that are identical for all practical purposes, except that they get hit with different shocks in different points in time.

You have to recognize that countries are fundamentally different in their endowments and the endowments of natural resources as well as potentially human capital and technological differences that are very persistent and don’t necessarily change from year to year. Recognizing these differences can lead you to draw new insights about the long-run behavior of these countries and the risk exposure of their currencies and so on.

Knowledge@Wharton: What will you do next as a follow-up to this research?

Roussanov: I’m continuing research in this area in several different directions. One is understanding the role of, for the shipping sector, global economic fluctuations between countries and how the frictions in the shipping sector impact trade between countries and through trade exchange rates and relative prices of goods in different countries. I’m also working more on specific commodity markets, not necessarily in connection directly with exchange rate, but understanding better the connection of commodity prices through the macro economy.

I have a recent paper with Rob Ready as well as with Eric Gilje, who is my colleague here at Wharton, on understanding the role of shale oil and the recent shale oil revolution in the United States and its contribution to the growth of the U.S. economy over the last few years. That does not directly touch on international implications, although it does connect to this earlier research because over the years the U.S. has shifted from being a net commodity importer to being a net commodity exporter country, simply because we’re importing a lot less oil and much less natural gas thanks to the shale gas boom. We are starting now to export natural gas and even oil, and that could potentially change the properties of the U.S. economy from the international macroeconomic standpoint as well.