The final strategy example that we will look at for active currency managers is that of optimizing the carry trade. We looked at the carry trade idea initially in earlier posts and will do so again in the nest few posts in the context of an appropriate strategy for currency speculators, when using a risk appetite indicator, for the purpose of gauging when are the best and worst times to buy higher carry currencies (and thus go short the lower carry currencies).
This combination of a risk appetite indicator and a basket of higher carry currencies can also be used for the purpose of currency hedging by an active currency manager who trades and hedges currency risk around their benchmark. For a currency speculator, the principle of the risk appetite/carry trade combination is that the basket of higher carry currencies should be bought when the risk appetite indicator is in either risk-seeking or risk-neutral mode and should be shorted when it is in risk-aversion mode. Similarly, the currency hedger could use this combination of indicators to go underweight the hedge relative to the benchmark in higher carry currencies when the risk appetite indicator is benign and overweight when the indicator moves into risk aversion. Such a strategy should reduce transaction costs relative to a passive currency management programme, while also reducing the portfolio’s overall risk and adding alpha.
Yet, we can fine tune this strategy still further using a portfolio optimizer to take into account the volatility and correlation of currencies in addition to their yield differentials alone. This should both in theory and practice produce better returns than the simple carry trade strategy. The carry trade can be an excellent strategy by itself for adding alpha, however it can also exhibit substantial volatility at times. A fine example of this was when the dollar–yen exchange rate fell by around 15% in the space of a few days in October 1998. By comparison, the optimized carry trade would in the case of the currency speculator represent the buying of higher carry currencies with low volatility and the selling of low carry currencies with high volatility. For the currency hedger, this would in turn mean going underweight the hedge relative to the benchmark on higher carry currencies with low volatility and overweight the hedge on lower carry currencies with higher volatility.
For both a portfolio manager who is looking to hedge currency risk and an active currency manager who can trade that currency risk, optimizing the carry trade can be a useful and productive way both to reduce risk and to add alpha. Indeed, it is an improvement on the differential forward strategy in so much as that is another expression of a basic carry trade strategy. The optimized carry trade strategy has consistently produced good returns with of necessity less volatility, resulting in higher Sharpe and information ratios.
It should of course be noted that just as one can optimize the carry trade for improved performance over the simple carry trade, so one can do exactly the same thing for either the differential forward strategy or the trend-following strategy. One does this by looking at volatility-adjusted exposure rather than the simple exposure per se. Thus, for example in the case of the differential forward strategy, one can over an extended period of time look at the relationship between implied volatility and historical volatility of the underlying exchange rate. Optimizing for volatility-adjusted exposure, the active currency manager would increase the leverage of the forward hedge when implied vol is below a predetermined threshold relative to historic vol at the same time as the forward points are in favour of the hedger, and conversely lower it when implied vol is above. The extent to which this generally improves performance far exceeds any concerns about increased transaction costs. One thing which may have to be taken into account however is the likelihood that raising or lowering the leverage of a differential forward strategy, both on an absolute basis and relative to the benchmark, may have an impact on the volatility of the tracking error.
Similarly, one can seek to optimize through volatility-adjusted exposure the trend-following strategy. Again, this should improve on the alpha provided by the basic strategy. A final point on these active currency strategies is that they are obviously not dependent on the base currency for adding alpha given that the total portfolio weighting and risk remains the same whatever the base currency.