Here’s an FX Strategy That May Offer Refuge From Negative Rates

This leveraged Indian rupee risk-reversal has outperformed a plain forward carry trade over the past four years

Searching for yield? Think about sending your money to Mumbai.

Investors in Europe and Japan seeking to escape negative interest rates may be able to get attractive carry-trade returns by parking funds in a number of emerging-market currencies. A carry trade typically involves borrowing money in a low-yielding currency and investing the funds in a higher-yielding one. Doing so can earn the difference between the two interest rates. The risk: Adverse FX moves—the currency you invest in depreciating against the one you borrowed in—can quickly wipe out gains, or worse.

There are alternative trades, though, that might still make money even if the target currency weakens. A leveraged trade in the Indian rupee, for example, has proved more profitable over the past four years than a plain forward carry trade.

You can spot opportunities for carry trades and related strategies using the Bloomberg. The first step is to identify suitable currencies. Ideally, you’re looking for ones that offer relatively high yields with low volatility.

To find currencies with those characteristics, go to {WCRS <GO>}. Click on the Multiple Ranking tab for a chart that plots yield against volatility. For Basket, select Expanded Majors. Set the Base Currency as USD. For the X-Axis Ranking, select Implied Rate. Set the Term to 1 Year. For the Y-Axis Ranking select Implied Volatility. Again, set the Term to 1 Year.

 To compare the implied yields and volatilities of a set of currencies, run {WCRS<GO>} and click on the Multiple Ranking tab.

 To compare the implied yields and volatilities of a set of currencies, run {WCRS<GO>} and click on the Multiple Ranking tab.

The chart shows that the rupee offered one of the higher returns—an implied rate of about 7 percent. In addition, it did so with less volatility than other high-yielders, such as the Turkish lira or Brazilian real.

To evaluate a potential carry trade, it helps to have some indication of a currency’s future direction: To hang on to the strategy’s profits you want a currency that will remain relatively unchanged or—better yet—will actually appreciate.

For some insight into that, change the X-Axis Ranking on the chart to Forecasted Spot Return. Click on the arrow to the right of Term and select Quarter  1, 2017. Based on analyst forecasts compiled by Bloomberg, the rupee was expected to decline about 2.5 percent against the dollar. By contrast, the Brazilian real was forecast to drop 11.5  percent, the Turkish lire 8  percent, and the South African rand 5  percent.

So, judging by volatility, implied interest rates, and projected returns, the rupee appears to be an attractive carry-trade candidate. Selling a U.S. dollar-Indian rupee forward would be one simple way to set up a carry trade. There are other possibilities, however. Although not strictly speaking carry trades, these strategies offer the potential to profit from the interest rate differential between the two currencies.

A three-month leveraged U.S. dollar-Indian rupee risk reversal is one such trade. In the first leg of the deal, you buy a USD put with a strike price set at the at-the-money spot price and a notional amount of $1 million. In effect, that leg grants the right to sell $1 million in three months at the exchange rate prevailing when the deal was struck. In the second leg, you sell a USD call with double the notional amount of the put. The strike price of the call will be set so the entire strategy can be entered into with zero cost.

You can use the Option Valuation (OVML) function to price such a strategy. Using shortcut tails to indicate that the strategy has two legs, buying one and selling the other, with a three-month term, and so forth, run {OVML  USDINR  2L  B,S ATMS  P,72C  3M  N1M,2M <GO>}. In the USDINR column of Leg 1, use the drop-down in the Call/Put row to select Put. In the Offshore column of Leg 2, enter “?” as the strike. And under Strategy 1, in the Premium row, enter “0.” To calculate the strike price for the call option with a zero premium, hit <GO>.

OVML lets you price a three-month leveraged U.S. dollar-Indian rupee risk reversal.
OVML lets you price a three-month leveraged U.S. dollar-Indian rupee risk reversal.

To compare the profitability of this strategy to that of a plain forward, click on the Products button on the red tool bar and select Backtest. Set the Frequency to Quarterly. In the field below Frequency, select Final Date and set the date to Oct. 1, 2015. Set Occurrences to 16. Click on the Generate button.

When the calculations are complete, tick the boxes next to Cuml P&L, Cuml P&L of Fwd, and P&L. The white line shows the cumulative profit and loss of the leveraged risk-reversal strategy. The yellow line shows the cumulative P&L of a rolling three-month short forward strategy for the four-year testing period.

A backtest shows that the strategy has consistently generated gains over the past four years.
A backtest shows that the strategy has consistently generated gains over the past four years.

The graph at the bottom of the screen shows that the rupee has weakened against the dollar during the past four years. That’s a negative for a carry trade, yet the risk-reversal strategy has consistently generated gains. The Statistics panel on the right side of the screen shows that the total P&L of the strategy has exceeded that of the forwards by about $9,600 per $1  million of investment. What’s more, it’s also had less P&L volatility.
 
Grebenyuk is an FX derivatives specialist at Bloomberg in London.
 

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