1/ the Rise of Carry
1/ the Rise of Carry

1/ the Rise of Carry

1/ The Rise of Carry (Lee, Lee, Coldiron)

"Different forms of financial carry have always been central to modern financial systems.

"A problem arises when those that do not have the balance sheet to withstand a crash nonetheless engage in carry." (p. 5)


2/ NOTE: This book confirms some of my prior beliefs about the influence of central banks, but the evidence presented appears circumstantial to me.

I decided post the summary anyway because my skepticism may also represent a bias, so readers should really decide for themselves.

3/ "Carry trades share certain critical features: leverage, liquidity provision, short exposure to volatility, and small, steady profits punctuated by occasional large losses.

"As carry has grown in size, these features have begun to define financial markets themselves." (p. 3)

4/ "As asset prices fall and liquidity contracts, central banks act to stabilize markets, reducing volatility. Thus, the full extent of carry losses is never felt, and this allows at least some carry traders, who should have been wiped out, to survive. (p. 5)" https://t.co/wrM6cd0qox

5/ "Central banks are themselves “captured” by carry. During the intensely deflationary carry crashes, they appear to have no option other than to increase moral hazard further via even greater intervention and bailouts. Their seemingly immense power is mostly illusory." (p. 7)

6/ "Returns on projects look unattractive when set against financing costs at high Turkish interest rates. But if the entrepreneur is borrowing in US dollars at a lower rate and is complacent about the exchange rate risk, then magically the projects can appear viable." (p. 12)

7/ "This situation can only be sustained for as long as the outstanding currency carry trade keeps expanding. Once carry trade inflows moderate, then the currency will fall unless the central bank intervenes and uses its own reserves to support it." (p. 13)

8/ "The US dollar–funded carry trade has not grown in a vacuum. It has been made possible by a willingness of investors in other countries, notably central banks and sovereign wealth funds, to continually accumulate US dollar assets." (p. 18)

9/ 1998 "has colored all market behavior since and laid the groundwork for successively bigger carry bubbles. The knowledge that the Fed and other central banks stand behind them has made carry traders more confident in their levered bets on low financial volatility." (p. 26) https://t.co/CHcmOXJTI2

10/ "BOJ’s extreme interventions to prevent the yen appreciating, coupled with near-zero interest rates, made the yen an ideal carry funding currency.

"Also, unlike the United States, Japan was a natural carry trade funding country with a large current account surplus." (p. 27)

11/ For mortgages: "At the end of 2006, Swiss franc borrowing by Hungarian residents from domestic banks totaled US$20 billion—in a very small economy. The collapse of the total currency carry trade began in July 2008, two months before the collapse of Lehman brothers." (p. 29)

12/ "The more successful certain types of carry trade are, the more capital is attracted.

"The capital appreciation, which is not based on fundamentals such as the long-term potential for earnings or economic growth, results in imbalances between spending and income." (p. 35)

13/ "Selling volatility is equivalent to buying the dip—buying when others are forced to sell. This can be seen as akin to market making/providing liquidity. Given that carry traders are performing useful functions, they might reasonably expect a positive return." (p. 36)

14/ "At the heart of the mortgage bubble was a giant credit carry trade; high-risk mortgages were being financed out of low-cost funds.

"Carry bubbles concentrate risk in the hands of speculators or entities that do not have sufficient balance sheets to bear those risks." (p.36)

15/ "A carry bubble can occur without an obvious credit bubble—obvious in the sense of being clearly visible in macroeconomic statistics—as financial market innovation creates ever-greater opportunities for carry trades and therefore for the concentration of risk." (p. 38)

16/ "When the dollar value of GDP is so high, it makes debt sustainability ratios look better [masking serious underlying economic problems]—until the currency collapses in the carry crash. By then, it is too late for investors who took these indicators too seriously." (p. 45) https://t.co/pklhCKm9HH

17/ "Losses greater than 3% should happen about once every 11 years, or 3 times during our sample. In fact, the portfolio had daily losses of ≥3% 77 times, 25 times more likely than we would expect. Currency carry trade returns do not follow a normal distribution." (p. 52)

18/ "The worst months for the carry trade strategy are associated with jumps in stock market volatility [and negative stock market returns]. At the other end of the spectrum, profitable carry trade outcomes tend to be associated with a reduction in volatility." (p. 53) https://t.co/MeDwiNN83U

19/ "Developed market currencies show the same pattern. Most drawdowns occur in the first decade, but recent drawdowns are associated with large spikes in volatility and drops in the stock market... an increasing association of carry and worsening financial conditions." (p. 55)

20/ Koijen et. al. find that implementing carry in a diversified set of asset classes (as opposed to just currencies and volatility selling) has positive skewness: https://t.co/pfgQVyF0RN

but the strategies may still draw down together during recessions: https://t.co/ZxCOo0fNb3

21/ "The chart also shows the correlation between short volatility and carry returns trending upward. The same pattern is present when looking at the currency carry trade with just developed market currencies, so this is not due to the inclusion of emerging markets." (p. 59) https://t.co/DStKpqV3Uk

22/ "VIX rolldown historically earns profits from shorting S&P 500 volatility. They find that most of the returns from a currency carry portfolio can be explained by exposure to this short volatility strategy." (p. 59)

This is the paper the authors cited: https://t.co/b1rLPTCETV

23/ "The poorer results for currency carry over more recent years have coincided with a narrowing of the difference in global interest rates, particularly in developed markets." (p. 60) https://t.co/PWpSyDnqgp

24/ "Increasing leverage in developed market carry would increase risk [lower returns for the same volatility and somewhat higher correlations].

"Emerging currencies are far less liquid than developed currencies.... we can expect future unwinds to have sizable impacts." (p. 62) https://t.co/IDzcn3pQCS

25/ "Since drawdowns happen during bad times, a carry trader should have liabilities that are very long-lived or do not increase meaningfully during bad times.

"Institutions that report returns over short time horizons have an incentive to utilize carry's steady returns." (p.70)

26/ "Cash bonuses based on quarterly or annual P&L encourage strategies with carry-like cash flows.

"If carry crashes occur at long intervals, then levered negative carry traders may already have been forced to close their positions and never get to realize profits." (p. 71)

27/ "While hedge funds' short-term liability profile argues against carry, their compensation structure creates a strong incentive in the opposite direction.

"Moreover, a trader’s bonus virtually always contains some component linked to performance." (p. 73)

28/ "While LTCM’s use of leverage was extreme, the same principles apply to any levered portfolio; both its influence on markets and its instability, particularly during bad times, are increased." (p. 74)

Nicholas Dunbar tells LTCM's story here: https://t.co/KG3EeUE7zn

29/ "A hedge fund that turns its holdings over every month will end the year having owned 12 separate portfolios. This fund could have 10 or 20 times the impact on market prices compared to a more traditional fund that holds securities for multiple years." (p. 74)

30/ "2008 was a terrible year for carry and coincided with a run on investment bank liabilities, resulting in a global crisis. That these institutions still engaged in carry despite having liabilities ill-suited to them speaks to the power of their compensation incentive." (p.77)

31/ "Classic carry uses borrowed money to take positions in high-yielding assets with less liquidity. This is precisely what private equity funds that focus on leveraged buyouts do.

"They may be extracting significant fees to create portfolios of simple levered equity." (p. 78)

32/ "If the S&P 500 had not bounced back so much after March 2009, then private equity valuations would eventually have had to catch up—or rather, “catch down”—with public markets. This return smoothing resembles the bet on mean reversion that volatility sellers make." (p. 79)

33/ "The buyout industry is cyclical, so point-to-point comparisons can be misleading. That said, the scale of capital being employed in these deals is now much greater than it was 20 years ago. The last five years have been the strongest in the industry’s history." (p. 80)

34/ "Dollar bond issuance is more prevalent when carry looks attractive... Emerging market companies engage in carry-like behavior.

"With restrictions on financial firms, nonfinancial corporations act shadow banks, raising funds in US dollars and lending to other firms." (p. 81)

35/ "Corporations take advantage of very low rates on their own debt to finance higher-yielding investments: non-US companies borrowing in dollars to buy higher-yielding domestic currency assets and US corporates borrowing at low rates to buy back their own equity." (p. 83)

36/ "When the marginal (and levered) speculator demands market liquidity, the carry trader is the supplier.

"In markets which do not have the same market depth and range of instruments available, some hedging of risk will take place in US market instruments." (p. 86)

37/ "In its more limited form, carry can be a motor, or at least a lubricant, for progress. The problem occurs when carry comes to dominate markets, in which case it can manifest in forms that could be considered rent-seeking or even corruption/infringement of liberties." (p. 88)

38/ "A levered speculator, trading with the market, is buying optionality.

"In expectation, trading with the market costs an amount directly proportional to volatility squared, or variance. (This is sometimes referred to as volatility drag or variance drag.)" (p. 94)

39/ "The fact that many people and institutions are systematically short volatility does not necessarily mean that long-run returns to selling volatility will be low. It only necessarily means that volatility will be prone to extremely severe short squeezes." (p. 98)

40/ "The S&P 500, through the derivative contracts tied to it, is used to hedge positions and risk in a wide variety of less liquid instruments. The S&P 500 is the world’s hedge, absorbing the optionality demand, and therefore premium, from less liquid instruments." (p. 99)

41/ "In expansion phase of the carry regime, a range of assets begin to be held as money substitutes because of their apparent stability. Of course, this stability is illusory, and when the true risk is revealed in a carry crash, the demand to hold “true” money explodes." (p.101) https://t.co/Iv2WCOC6Pt

42/ "The Fed became possibly the biggest carry trader of all: large holdings of Treasuries and MBS financed by very low-cost liabilities.

"The carry regime emerges as a series of successively larger bubbles and busts as central bank intervention increases in each cycle." (p.103)

43/ "In a carry regime, in which the volatility of asset prices is suppressed, a greater range of financial assets begins to appear more money-like and, eventually, to seem as good as money.

"The central bank loses direct control over the effective supply of money." (p. 112) https://t.co/3vMojllCm7

44/ "The carry regime in itself is fundamentally deflationary over the long run through high and increasing systemic leverage, associated with increasing debt.

"Other things being equal, if debt levels are too high relative to incomes, demand for credit will be lower." (p. 114)

45/ "GDP today occurs at the expense of GDP in the future.

"The carry regime is taking us away from an economy in which risks are borne by individual businesses and institutions and priced in the market, to an economy in which risks are socialized (or perceived to be)." (p. 116) https://t.co/ZAQpevFaaG

46/ "A carry crash is the means by which traditional market forces manage to exert themselves.

"With higher volatility, the demand for true money rises sharply. This means rapid deflation unless the central bank is able to expand the true money supply very quickly." (p. 122)

47/ "High asset prices do not guarantee that the economy is “good for now.” A carry crash can occur suddenly when leverage becomes unsustainable. Rather than somewhat smooth oscillations, the business cycle is steady, unspectacular growth interrupted by violent shocks." (p. 127)

48/ "If there is a carry crash in instruments that are less money-like, such as commodities, speculative funds may be channeled into other carry trades. As liquidity starts to evaporate, certain carry trades may crash while other carry bubbles become even larger." (p. 128)

49/ "An oil carry trade should be more vulnerable and short-lived compared with a stock market or currency carry trade. Without the direct interference of central banks, the oil carry trade merely delays somewhat the inevitable market price adjustment." (p. 131)

50/ "Structured finance, in a sense, arose to fulfill the desire for carry and enabled the mispricing of risk that carry entails.

"Quantitative easing is itself a giant carry trade, financing higher-yielding debt instruments by issuing low- or zero-yielding liabilities." (p.136)

51/ "Successive carry bubbles develop in a way that disguises their nature. If, after the Internet bubble burst in 2000, there was immediately another, identical, Internet bubble, would have been difficult to surpass the scale of the original. People are not that stupid." (p.137)

52/ "Short-term profits can be high: company management may issue debt at lower rates and to invest in an asset that has a current earnings yield. If many others are doing the same type of transaction, prices will be driven up as well, producing capital gains." (p. 139)

53/ "The observation that daily volatility exceeds monthly volatility implies that returns are mean reverting. Large short-term moves in one direction are likely to reverse partially over longer horizons." (p. 152) https://t.co/N5Ds6rODJF

54/ "Prior to index futures, implementing a momentum strategy such as portfolio insurance would have been rendered impractical by trading costs. It is likely that in the distant past, the mean-reversion premium was subsumed by wide bid-ask spreads for individual stocks." (p. 155)

55/ "The volatility of the US equity market over horizons of >5 years has always measured substantially below its 1-year volatility. This provides perspective on the effectiveness of long-term valuation metrics (Shiller P/E, Tobin’s q) without reference to fundamentals." (p. 156)

56/ "It seems likely that the only short volatility premium before 1987 was the market-maker’s premium (and equivalently, the implied-realized gap). Other forms may have been negative: volatility buyers got paid as with short-term momentum across many asset classes." (p. 159)

57/ "Negative correlation emerged in October 1997; prior to that, stocks and bonds were positively correlated. The shift could have been caused by market recognition of the deflation thread or that monetary policy would now react directly to changes in stock prices." (p. 161)

58/ "The implied volatility term structure curvature is a risk premium paid to forward implied volatility sellers/liquidity providers. In the same way, the gap between implied and realized volatilities is a risk premium paid to providers of instantaneous liquidity." (p. 164)

59/ "The hypothetical opposite would be anti-carry: inflation out of control. Demand for true money would collapse. The demand for (at least some) risky assets would rise relatively. During the dislocation, risky assets would appear better than money as inflation hedges." (p.170) https://t.co/MrrYOPsFXD

60/ "Carry trades leverage a difference in yields between a source and use of funds.

"The neediest borrowers are also the riskiest and have the highest probability of default [in the event of a carry crash]. The neediest borrowers can also be squeezed the hardest." (p. 180) https://t.co/r0WyoLFRq3

61/ "Capitalism includes free markets, businesses operating in a competitive environment, private/transferable ownership of businesses, and governments that provide rule of law and ensure a stable medium of exchange. What we have today is closer to financial corporatism." (p.195)

62/ "On Wall Street, a whole generation (possibly more) of investors and professionals has “grown up” in the carry regime. It's the way people think. Interventionist central bank and government policies “work,” so interventionism becomes mainstream thinking in economics." (p.201)

63/ "There is some evidence that once the implied volatility curve inverts, short-term volatility continues to trend higher. However, the timing here has to be exquisite." (p. 204)

Here is a relatively readable paper (out of many) on the subject: https://t.co/ZnE2xGBzWx https://t.co/W9MFs4OtNL

64/ "It may be rational for investors to buy into the bubble: no one gets fired for being long the S&P 500. In a crash, they expect central bank intervention. Virtually all investors will be suffering as well, so no institution is likely to be singled out for criticism." (p.205)

65/ Two of the traders in Hedge Fund Market Wizards rode bubbles but hedged using options because they judged implied volatility to be relatively cheap:

Colm O'Shea https://t.co/nZWFx7hXYT

Jamie Mai https://t.co/QwIV15VAok

66/ "An inflationary anti-carry regime must be associated with the direction of the volatility premium changing from short to long [IV backwardation, short-term trends, and vertical skew reversing]. People will eventually come to believe these conditions to be normal." (p. 214) https://t.co/g2YBh0gnJB

67/ "If stubborn inflation emerges, it is likely to be a precursor to the end of the carry regime entirely. Once high inflation is entrenched, central banks have lost policy flexibility, and ultimately new monies, not reliant on central banks, will be likely to appear." (p. 216)

68/ "The Fed was created to bring stability to the banking system.

"The process of change was not discrete, uncontroversial, or even initially successful.

"Change is not unprecedented; the result ends up being a lagged reflection of society’s key economic concerns." (p. 218)

69/ "The Fed in an unenviable and ultimately unwinnable bind. It born to stop financial panics from infecting the real economy, so it must act in the wake of a carry crash. Yet this is increasingly seen as helping the elite and as reinforcing unfair economic outcomes." (p. 219)

70/ "2007–2009 was the most recent opportunity for authorities to allow traders to suffer catastrophic losses in order to unwind some of the economically damaging structural effects of carry. That opportunity was lost, and the carry regime has been strengthened further." (p. 220)

71/ https://t.co/6QSZE78qMx

72/ https://t.co/TJB8y9wM45

73/ "Carry is a fundamental part of the markets and in the economy as a whole.

"This is a very ambitious book, and in places, its ambition causes it to overreach. Nevertheless, this is an important book. Carry is important, and is not going away."


74/ https://t.co/K4Tj9c0d12