Tim Owens, head of currency and commodities solutions, JPMorgan: If you can’t get carry, go for correlation

^{Lee Oliver, Euromoney’s FX correspondent, is taking a well-deserved summer break. While he enjoys the clean air of the Alps, The weeklyFiX is supplied by guest writers from the industry. Our second contributor is Tim Owens, head of currency and commodities solutions at JPMorgan.}
At the time of writing the financial markets are still showing signs of turbulence, as concerns over credit markets have risen and most indicators of risk aversion have crept up. In foreign exchange markets the level of implied volatility has increased sharply. JPMorgan’s VXY index1, which measures the level of G7 FX rates implied volatility, was noted at 8.09% on August 10 2007, after fixing at a lifetime low of 5.67% in early June 2007. Nonetheless, despite the recent rise, FX volatility is still trading well below its long-term mean2.

A benign cyclical environment, where abundant liquidity has fuelled a growing appetite for risk, and an enhanced level of transparency from monetary policy makers have resulted in unprecedented low levels of FX volatility. Structured transactions in the FX markets have also contributed to low levels, enabling investors to sell volatility easily. An example of this type of trade is the dual currency deposit. Such trades are often enhanced by various features that increase the coupon paid (eg, by allowing for the multi-currency settlement of the principal or worst-of deposits) or reduce the risk of the sold options (by adding knock-in features that require predetermined triggers to be reached before the embedded options can be exercised). Similar techniques have also been applied to hedging solutions, allowing corporations to monetize their indifference to the amount of cashflow hedged by committing to hedge future cashflows at better than current market levels.

As a result, the market has had an abundant supply of cheap FX options. The risk management activities of inter-bank buyers of these options have led to continued delta-rebalancing – buying spot when it trades lower, selling it when it is higher – exacerbating the range trading conditions and driving realized and implied volatilities lower. In this environment the carry trade has flourished. The market has delighted us with stories of Japanese housewives actively trading FX on margin to benefit from the higher yields offered by the Australian or New Zealand dollar over Japanese yen. Notwithstanding several spikes in risk aversion over the past year, the carry trade and Mrs Watanabe have remained remarkably immune to shocks. JPMorgan’s IncomeFX index, which tracks the performance of a carry-trading strategy in G7 markets, illustrates this rather well. In May 2006 and February 2007 risk aversion triggered by events in Turkey and China resulted in market participants exiting the carry trade. In both cases the shock was short-lived; the retracements of about 6% were quickly recovered. In the most recent case, barely one month had passed before the retracement was fully recuperated. This current bout of risk aversion has a different anatomy. Well-signalled problems in the credit markets gave market

participants an opportunity to hedge with cheaper long-dated options, calendar spreads and longer-dated forward volatility agreements³. As a result the implied volatilities across the curve have risen in most G7 FX markets. Nonetheless, as noted above, volatilities still remain below long-term means and we see potential to profit from entering long volatility trades at these levels. Another feature of the recent behaviour has been the indiscriminate investment into carry trades. As noted above, margin trading in Japan has frequently been cited. This has resulted in a rise in the correlation between Japanese yen-crosses. Chart 3 ("Correlation across JPY crosses") illustrates this by reference to the average historical three-month correlation between AUD, NZD, GBP, EUR and USD rates versus JPY. Correlation between these pairs peaked at a level of almost 90% earlier this year and is currently closer to 75% (having seen levels just above 30% one year ago). The rise in correlation has increased the cost of basket options. The basket option of the above currencies versus the JPY offers a mere 10% discount versus the strip of options.

In the current climate we remain less concerned about a total withdrawal from the carry trade; IncomeFX has suffered a drawdown, but its magnitude (less than 5%) has not been without historical precedent. Looking forward we expect market participants to be more selective in their choice of carry trades. A divergence of the performance between carry trades is likely to result. Given the high level of correlation noted above we have seen interest in correlation trades such as dispersion trades. Dispersion trades offer the potential to profit from this divergence and from higher levels of volatility.

In the context of the recent market turbulence we see potential for a continuation in the rise in FX volatility. However, the size of the drawdowns currently being experienced in carry trades is not unusual and carry trades are likely to continue to be attractive. This would likely change if we were to see a more substantial shift towards recessionary expectations in the US. We therefore continue to recommend carry investments but remain cautious about indiscriminate investments in carry. We also expect a breakdown in the levels of correlation, which should give rise to interesting opportunities for correlation trades.

Notes:

1) Available on Bloomberg ticker JPMVXYG7 or Reuters page JPMVXY

2) The lifetime average level of VXY since June 1992 has been 10.2

3) A Forward Volatility Agreement (FVA) is a commitment to buy an option in the future at a pre-agreed level of volatility.