In 2006 Howie Hubler was a trader for Morgan Stanley. He correctly predicted that US house prices would fall, and that sub-prime mortgages would be decimated in value. Despite this pinpoint forecasting accuracy, Howie managed to lose around $9 billion in the ensuing financial crisis. It is still the second largest trading loss in history.
How did Hubler manage to get it so right, and yet lose so much? His bet on falling mortgage prices was a negative carry trade. To hold the position he had to make regular payments. To finance these Hubler put on a compensating (positive) carry hedging trade, betting on other mortgages that were purportedly safer. But to make the books balance he had to leverage his hedge, taking a position that was eight times larger. When the market imploded in 2008 Hubler’s bearish bets paid off handsomely. Unfortunately the ‘safer’ assets were also decimated, and a potential $2 billion profit became a catastrophic loss.
The carry trade is well known and well used by financial traders, but has a low profile elsewhere. Unlike more well known trading strategies, such as momentum and value, it has attracted relatively little attention in either the academic or popular financial literature. Nevertheless, the carry trade has been responsible for many other trading disasters, including the 1998 LTCM crisis and Nick Leeson’s infamous destruction of Barings bank a few years earlier.
In my own career I’ve come across it many times. As an inexperienced investment bank trader I was admonished by a senior trader for being ‘short naked gamma’: selling options in the market without the safety net of delta hedging, an especially dangerous variation of the carry trade. A few years later in 2008 I was managing a hedge fund carry strategy which lost a third of it’s notional capital in a matter of weeks. Thankfully, we had reduced it’s risk allocation for unrelated reasons, saving our clients hundreds of millions of dollars. I still trade carry today, although only as a minor component in a diversified portfolio of strategies.
So my curiosity was piqued when I discovered that carry is the subject of a new book by Tim Lee, Jamie Lee, and Kevin Coldiron: ”The rise of carry: the dangerous consequences of volatility suppression and the new financial order of decaying growth and recurring crisis”.
Defining carry is harder than you think. One definition the authors offer is ‘an activity that provides a steady premium income but exposes the seller to occasional large losses‘. To mask £200 million in hidden trading losses Nick Leeson had to sell options which generated cash premiums. The Japanese market crashed after the Kobe earthquake, and Leeson eventually lost over £800 million.
But, as the authors point out, carry trading is not limited to rogue traders. Collecting steady premia is what an insurance company does. Banks, who borrow and lend to earn an interest rate spread, are also carry trading. But insurers and banks diversify across many customers, transforming a portfolio of risky bets into a benign balance sheet. In contrast, most carry trades in the financial markets are correlated in market crashes, so true diversification is hard to find.
Another definition offered in this book is ‘Carry trades make money when “nothing changes”’. The FX strategy I was running in 2008 fell into that category. If exchange rates are stable then it is profitable to lend money in a higher yielding currency, whilst borrowing in a low interest rate country.
Notice that the FX strategy will benefit if exchange rates remain constant, but will profit further if the higher yielding currency appreciates. Only an appreciation of the lower interest rate currency will create losses. Even then we have the cushion of the interest rate differential to compensate us, unless the price falls too much. That is what makes carry such a tempting prospect.
But this is subtly different from the other infamous carry strategy of selling optionality in the market, AKA ‘short volatility’ or ‘short gamma’. To get technical, like Nick Leeson you will sell straddles or strangles, combinations of puts and calls. Here you will lose money if the price moves in either direction. Furthermore, as was once pointed out to me with the use of many four letter words, you will probably lose even more if you fail to ‘delta hedge’: trading the underlying instrument to reduce your exposure to further adverse price movements.
The authors do not make this distinction sufficiently clear, defining carry as a trade with ‘short exposure to volatility’. This is correct for short volatility trading, but not for FX carry where only volatility in the wrong direction is problematic. But perhaps I am being too pedantic. Higher yielding currencies are usually emerging markets. These get hurt when risk levels are elevated, whilst lower yielding currencies are normally ‘safe havens’ like the US and Japan.
However the world has changed. Currently the US dollar has an interest rate more than 2% higher than that of the Euro. A carry trade where US dollar deposits are funded by Euro loans would not necessarily do badly in a global market crash.
Leverage also forms an important part of the definition of Carry as defined by the authors. FX carry trades often yield a desultory sum, like the 2% a year currently available from the USD/EUR pair. This would need to be leveraged several times to get a reasonable return. Naturally, option selling is an inherently leveraged activity. As the authors rightly say, the use of leverage is a key characteristic of carry trades. A carry trader who uses no leverage can ride out any storm. But with high leverage, the slightest adverse price movement will wipe them out.
Perhaps a third of the book focuses on carry as a trading strategy, mainly in it’s FX and short option flavours. There are plenty of warnings about the danger of carry trading, but this is not a detailed instruction manual for prospective carry traders. They would be better served by reading the relevant chapters of books by Lasse Pedersen (“Efficiently Inefficient”) and Anti Ilmanen (“Expected Returns”).Particularly absent is any in depth discussion of carry in other financial instruments. The seminal academic paper in this field is the aptly titled “Carry” by Pedersen et al. They find that carry works well across all asset classes. More interestingly they find that the ‘skewness’ of carry returns is only significantly negative in FX and short options markets. In other assets carry has no significant skew, and unusually in bonds it has some positive skew. Hence the only instruments where carry is particularly dangerous, evidenced by a negative skew, are the most notorious markets which the “Rise of Carry” chooses to focus on. It is a pity that the authors were unaware of this evidence, or perhaps chose to ignore it in favour of a better story.
Traders do not especially care their strategies affect the operation of the market more generally, but the authors do explore this interesting facet of the carry story. I particular enjoyed their description of selling vol at short durations, then buying it at long durations. This nicely fits certain stylised facts of market behaviour: mean reversion at shorter horizons, and momentum at longer horizons.
Volatility is usually seen as a bad thing, and stability is universally appreciated, but the subtitle of this book ‘The dangerous consequences of volatility suppression…’ makes the authors contrary views clear. Unusually low volatility can trick market participants into thinking the world is safer than it actually is. They will be encouraged to use more leverage, assuming that a large market move is very unlikely. The price of volatility is like the porridge in the Goldilocks story. We don’t want too much or too little: it needs to be just right.
What effect does a short volatility trader have on the market? The authors are not explicit here, but a simple thought experiment may help. Consider first the delta hedging trader. If the market rises, they are forced to buy. If it falls, they must sell. Their actions will increase market volatility. Interestingly, if they have sold their option to another delta hedged trader, then their actions will be exactly mirrored by the buyer. There is zero net effect on the market, since their trades will exactly offset (assuming the same hedging strategy is used).
At first glance an unhedged short volatility position has no effect on the market. But it is very likely that an unhedged trader has sold their options to a market maker, who will usually be delta hedged (unless they are young and callow). The market maker is long volatility, and hedges by selling as the market rises, and buying on dips. They will reduce the volatility of the market.
More volatility sellers than buyers will reduce the price of options, and hence implied volatility will fall. But realised volatility could go either way. Short volatility traders are not always the villains that they appear to be.
The more ambitious parts of the book are those that discuss carry as a wider phenomenon that affects large parts of the economy; from international trade to domestic macroeconomics, and even as a possible cause of economic inequality. The section on international financial flows is both original and interesting. But this may be less relevant if the US dollar is no longer the go-to currency for financing carry trades.
With respect to the macro-economy, the authors tell a familiar story: when interest rates are low, people seek out high yielding riskier investments. Yields are crushed, and leverage is needed to compensate. The bubble leads inevitably to an eventual crash. But by viewing it through the prism of carry the book reveals some interesting insights. In particular they point to the important role played by central banks in rescuing speculators from disaster. In the 1990’s it was the Japanese Central bank that kept USD/JPY carry traders afloat by keeping the Yen weak. Keeping Toyotas cheap in dollar terms was worth the cost of supporting the currency. In the 2010’s it was Quantitative Easing. Saving the global economy was also worth it.
The role of QE in inflating asset prices, and hence increasing inequality, is also well known. The distribution of wealth is notoriously uneven and higher asset prices exacerbate it further. The authors also note that those with more wealth will benefit more from carry. The rich can choose to use lower leverage. A deca-millionaire can live off a 2% unleveraged return, but a less wealthy person would have to leverage it up several times. Similarly, an asset rich person can sell covered calls on their stock portfolio to earn a short volatility premium. This will never lead to margin calls, no matter where the market goes.
This is a very ambitious book, and in places its ambition causes it to overreach. Carry is a fundamental part of the markets, and to some degree in the economy as a whole. But linking it to human evolution as the authors do in the final chapters, seems rather tenuous to me. Nevertheless, this is an important book. Carry is important, and is not going away. It will always be an attractive strategy.
After all, the trader who earned the most out of the 2008 financial crash was a certain John Paulson. Unlike Hubler he did not hedge his negative carry position, and had to keep paying premiums, dragging down the returns of his eponymous hedge fund. Many investors balked at the cost, and pressured him to close the position. Keeping such a trade in place requires nerves of steel. When the market finally broke Paulson earned billions for himself and his fund, but it was not an easy ride. Earning a steady stream of carry returns is a much more tempting prospect for most.
Robert Carver is an independent trader and visiting lecturer at Queen Mary, University of London. He is also a former investment bank options market-making trader, and former hedge fund portfolio manager. Robert is the author of three books: “Leveraged Trading”, “Systematic Trading” and “Smart Portfolios”. His website is systematicmoney.org