carry trades

A Factory Called The Euro : The Logic of Carry Trades

Sanjeev

Sanjeev

Think of it as a factory, or an SBU. The advantage over a physical factory is that our investment can be retrieved with very short notice; hence short-term (Working Capital) funds can be used to fund such activities. This would be a factory without any labor costs, any strikes and lockouts, no big Accounts and Admin Departments, and no big offices (or even physical factories). Yet it produces a return in the same way that a factory does. It is superior to a factory because you can vary the amount invested based on your appetite. If you need money for a house, just reduce your positions; you don’t have to sell your ‘factory’.

Disclaimer: This article was written originally in June 2011, so some data points may be outdated.

The process of growth

Most important, is the process of growth. Like any factory, you make money after you start to do things right, relative to the market. However, in the case of a factory, most businesses hit the rough when they set out to grow, i.e. set up the next factory. Here, they face a set of completely new variables, new skills, and a whole new set of risks altogether. Since a company does not get many opportunities to set up a factory, it does not have much mistake-proofing built into its Project Management processes. And this is where many companies make grievous mistakes, leading to either a broken leg or even a broken neck. This is why the Capex cycle is synonymous with a Business Cycle.

So what if I offered you a ‘business’ that is ‘frictionless’, i.e. it has no costs, no people, no strikes/ lockouts, and no transport/ logistics breakdowns? There is no ‘project’ phase, during which the business has to go through trial runs, absorb spikes in material wastage, or find new customers for its additional production (or suffer extra warehousing and inventory-carrying charges while it waits for Business Development to deliver orders). Growth is also frictionless, i.e. there is no cost, no dislocation, and no faltering in the business during the scale-up.

Here is what you do. Look for a low-interest currency. Usually, interest rates are low where the savings rate is high, like in the JPY. But once in a while, you get low-Interest Rates with low savings, like is being done by the US and European Central Banks just now.

The Economic Argument

The Forward Curve is related to the Interest Rate differential between any 2 currencies, after adjusting for the expected direction in Interest Rates over the foreseeable future. ‘Carry traders’ move money from one currency to another, betting on the fact that they will get higher Interest rates in the currency bought. Often, the relative levels of Inflation in the 2 currencies also impact the Forward Curve, provided real interest rates remain the same or move in a narrow range. When this is not true, the Forward Curve gets disproportionately steep. Since real interest rates are a function of country risk, they reflect risk premia.

If real interest rates are high, and risk premia are also high, it follows that the Equity Risk premium will be higher, reflected in low Market P-E. That makes the country a better investment bet in Equities.

In the case of the Euro, for example, interest rates are low, despite a low savings rate because of Central Bank intervention AND the fact that a sluggish domestic economy has little room for any credit growth. This makes it a candidate for a ‘carry trading’/ funding currency, i.e. borrow in Euro at 1.25%, and lend in the Rupee at 8%. At the end of the year, sell the Rupees and when you go to buy the Euro, it should have not appreciated much. An appreciating Euro will hurt Greek and Portuguese exports, widening their Current Account Deficit, thus bringing the Euro back to square one. Certainly, the Euro looks unlikely to appreciate 6.75% per year, ad infinitum.

The Traders’ Argument

Volatility and volumes are good, even as the high-low band remains relatively small, and the number of one-way movements has been limited. If you use a technique of “rupee cost averaging”, you would be selling at all levels and buying back at all levels. This strategy presupposes that the total of all candlesticks is many times (>20) the actual risk of loss (a.k.a. maximum possible loss, i.e. Value at Risk, VaR). Hence, you stand to lose, say, Rs.100, but you recover say, about Rs.500 from all the systematic trading that you do.

It all looks (and sounds) very complicated, and the interested reader might want to read this a few times over. But at its root, it is an Insurance company operation, i.e. there is a premium flow receivable every time you write a policy. Even though a lot of people are involved in finding the customer/ insurer, capturing the Insurance premia, and servicing claims, that is NOT the reason an insurance co makes money.

You can do away with all this, and still make as much (if not more) money as the Insurance co; it is called (buying and selling) reinsurance, which is nothing but trading of income streams with probabilistic claims attached to it. At the net level, you are buying a series of positive and negative outflows for an NPV. Assume that over some time, these positive and negative flows cancel each other out, leaving a ‘net return’ that meets the cost of capital. But the return is lumpy, i.e. there are periods of high profitability followed by periods of sharp losses.

Cut to the rest of the real world

Cut to the rest of the real world. The same thing happens in all markets. In the cyclical sugar industry, the turnover may be more or less equally spread over 4 years, but the profits come to 60% in 1 year, 30% in another year, 20% in a 3rd year, and the 4th year carries a loss. This causes a huge variation in a trader’s income stream, but if he can avoid the sharp price corrections that take place at the top of the cycle, he can make big returns over the rest of the cycle.

If you can sell a low-interest rate currency close to the top of its movement, you have actually ‘bought’ the high-interest (and savings deficit) currency. In the case above, you borrow from Euro at 1.25% and ‘lend’ to India at 8%, getting a 6.25% currency differential in the process. This ‘carry’ is nothing but the Forward Curve, visible over a year. In the Indian currency markets, it is the ‘rollover premia’, which you get, against which you have to provide for a ‘claim’, i.e. the probability that the Euro will appreciate.

Now, through the economic arguments articulated above, we know that there is little logic for the euro to appreciate, so the probability of a claim for a long period is low. Oh yes, there will be short spikes, which will have to be funded, but since they reverse quickly, your carrying cost is low.

Look back at 2002, and you will see the $:: Re at Rs.42. If someone had sold it then, and carried a short for the last 9 years, he would have earned about Rs.21 in ‘carry’,  And the $ is back at more or less the same level; so the strategy does work over the very long-term.

Insurance and reinsurance

For any individual who is willing to work hard and understand all this, you can build your Insurance co, which will be far more profitable than almost any company in India. You can build a Pension Plan that outperforms almost any scheme sold to you by these big institutions. If you are a company, you get to outperform your industry by a mile.

According to one of the Berkshire Annual Reports, this (reinsurance) strategy is the real reason for their ‘negative cost of capital’, and contributes more to their cumulative outperformance than their long-term Investment Return of 23%. The reason for this is simple: a negative cost of capital allows you to theoretically take unlimited leverage. The more your leverage, the more you earn. And the leverage is self-liquidating. If your effective cost of capital is MINUS 4%, the returns from this leverage will automatically take your leverage to zero in about 10-15 years.

Do the math, and you will shock yourself. Companies that believe that low leverage is an unmitigated virtue, have not understood this. That the Master of Capital Returns (Warren Buffet) is a fine practitioner of the art of leverage…even as he extolls the virtues of low leverage to those who don’t understand the ‘negative cost of capital’.

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