The demise of the carry trade and its associated components is
without parallel in the history of modern currency trading.But the extraordinary rise and fall of the carry
did not take place in the isolation of the currency markets.It was part of the worldwide search for
trading profits fueled by cheap credit, leverage and the ability to flash money
around the world in an electronic instant.The same factors that propelled the carry higher and then wrote its
collapse drove the commodity markets, the mortgage industry and equities to
success and distraction.
Instead of looking at the carry trade in light of
traditional parameters for the currency markets--interest rate differentials
and the competitive economic conditions of the currency countries--let us consider
it from a credit and leverage point of view. What effect did the tremendous
increase in available credit for currency market participants have on trading
in the yen crosses? What will be the effect of its sudden and probably
Credit availability in the cross currency market had a two-fold
impact.First, it encouraged
participation in the currency markets for traders and non-bank organizations.The seemingly permanent rise in the yen
crosses was at least partially fueled by players seeking the sure return of the
carry trade.Not only was there positive
carry or interest earned on the trade but buying the crosses drove the cross
rates and the value of the positions ever higher. It was a double benefit:
interest rate carry and position appreciation.
Whether participation in the carry trade stemmed from the
need to exchange funds borrowed at very low rates in Japan for use elsewhere or
for differential interest return and speculative profit, the effect on the
cross rates was the same; they were pushed relentlessly higher.The Euro, the Pound Sterling, Australian
Dollar and New Zealand Dollar were all propelled to historic highs against the
US Dollar at least partially as a side effect ofthe carry trade and what is called â€˜over
dollarâ€™ covering of cross positions.
For example, when traders want to take a long euro/yen position
they can directly buy the cross in the currency market, or they can buy the
euro against the US dollar and sell the yen against the US dollar and combine
the position into a long euro/yen position. The reason for this slightly more
complex transaction is price, sometimes you can obtain a better rate â€˜over dollarâ€™
that you can in the cross itself.This
procedure works with all the yen crosses.
The second effect was, and pardon the use, derivative.The availability of credit encouraged
increased participation in the carry trade, and this heightened participation served
to decrease volatility which in turn increased the predictability of profits. It
may seem counterintuitive that the more interest there is in a specific market the
lower the volatility. But the effect is a function of the available
In general, the more liquidity there is in a market the more
stable the pricing. Liquidity means that at most price levels traders will want
to do deals.It takes a liquid market
longer to traverse a price range and a shorter amount of time to dissipate news.
Smaller currencies, smaller in terms of trade volume, are inherently more
volatile. As the market moves in response to news or deal flow they have fewer deals
to absorb the selling or buying. A much smaller amount of volume can move the
market. Other factors being equal volatility rises as liquidity falls.
Volatility is, of course, not only a fact of low market
liquidity.External events are of equal
or greater importance.As we have seen
so dramatically over the past eight weeks, fear can propel markets far beyond
what would have once been considered rational prices levels.
One of the ways external factors influence price movement is
that they can limit liquidity. Players may choose to curtail their risk by not
participating in trading. This is certainly one of the factors that have given
all markets such a violent aspect in the past two months. Many potential new buyers have stayed on the
And that leads us back to the yen crosses. The daily ranges
of the crosses over the past two months are much greater that the average of the
previous five years.It is not only risk
aversion that has slammed into long yen cross positions causing so much
liquidation. The cessation of credit has contracted participation in the
market. As credit lines have been withdrawn from market players and yen loans
liquidated the participation rate and the trading volume in the crosses has
dropped.The sellers have been under
compulsion, the buyers are voluntary and absent.
The credit crash has affected participation rates in all
markets.Many speculative players who
depended on credit and leverage to fuel their trading have withdrawn. They will
not return anytime soon.In the
currency markets this permanent drop in liquidity may keep price movement
volatile long after calm has returned to other markets.It has substantially diminished liquidity in
the yen crosses which were, for so long, the speculative favorites of currency
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