Where's The Yield (Curve) - Pt 3

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July 29, 2022

2009 June 27, “The return of 'Mrs Watanabe'”, in Asia Times

"Mrs. Watanabe, the market’s metaphor for Japan’s housewife yen speculators, has come back to life.”

For this entire century, Japan has had some of the lowest, if not the lowest, government bond yields in the world. In fact, Japanese 10-year yields have not been above 2% since 1998. As a result, Japanese investors have been compelled to find returns on their portfolios in other ways. They have looked to stock and bond markets around the world. This has led to the characterization of the typical Japanese household who is seeking higher excess return globally, using the extensive household savings, moving financial markets globally. In 2009, Asia Times coined the term Mrs. Watanabe to describe this type of small retail investor.

Mrs. Watanabe will invest in these other asset classes for sure, but the go-to trade for Mrs. Watanabe throughout this century and the previous one has been the FX carry trade. Let’s first demystify that strategy before explaining how lower risk variations of the same like “cash and carry arbitrages” can be implemented and finally how this is actually very relevant in crypto.

The FX carry trade is one of the most popular trading strategies in the currency market. Mechanically, putting on a carry trade involves nothing more than buying a high yielding currency and funding it with a low yielding currency, similar to the adage "buy low, sell high."  The most popular carry trades for the Japanese retail investors involve buying currency pairs like the Australian dollar/Japanese yen and New Zealand dollar/Japanese yen because the interest rate spreads of these currency pairs are very wide. The first step in putting together a carry trade is to find out which currency offers a high yield andwhich one offers a low yield. From here, the daily interest can be calculated quite simply by:

This investor does not lock in a hedge for the exit strategy. Doing so would eliminate the gains, since the FX forward are also calculated by the interest rate differential. Thus, the investor is taking on the volatility of the currency pair in taking on the trade. Thinking this through, then, one can think of a sort of Sharpe Ratio of this trade as the expected return as generated from the sum of daily interest, divided by the currency pair volatility. As investors are considering on which currency pair to execute an FX carry trade, this is a ranking they can consider looking through the opportunity set.

One other thing to consider is not just the expected return (numerator), but also the risk (denominator). As we have seen empirically, implied and realized volatility across asset classes tend to move in the same direction. When there are risk flares in one asset class, it tends to work its way through to other asset classes. Think back to the piece we wrote on asset allocation. So, when we see risk in a market like equity markets, we know that it is becoming systemic when we see volatility in other assets. When we see this, we can expect and do see the unwind of FX carry trades, which means high-yielding currencies get sold, and money returns to the low-yielding markets.

As we have seen globally in the last few years, many if not most investors are in the same boat as Mrs. Watanabe. The FX carry trade is back in vogue.

Remember, there are two drivers to this trade – expected return and expected volatility. Let’s think of the latter first. Implied volatility is still relatively elevated across all asset classes, slowly but surely has been coming lower, led by equity volatility particularly as measured by the VIX. How about the expected return? If we think about what we are seeing from central banks, globally there have been more hawkish moves, as Australia, Canada, the EU and the US have all been hiking rates. However, Japan has been consistent in maintaining a stimulative policy. We can get into why that may be (that is the source of another post) but we have seen that continue, even as late as the July 21 meetings of the ECB and BOJ and the expectations of the FOMC on July 27. We can get an idea from this chart, where the low-yielding funding legs of the carry trade are, and where the higheryielding return legs are:

When we think of the FX carry trade, this is very much a spot (and daily forward roll) trade.

But not every carry trade has to be this risky - here you are taking the risk of a large move in the underlying two currencies which can easily wipe out your carry returns, since they would in general not move together. But consider two similarly correlated assets - then that carry you receive can be thought of as much lower risk.

This sort of risk and return profile using the futures market is occasionally possible, and this is definitely  more applicable in the cryptocurrency market.

This trade has been around as long as the futures market itself and is generally referred to as the “cash-and-carry” trade or “cash-and-carry arbitrage”. The mechanics of this trade are relatively easy to understand. Quite simply, one would buy spot, sell the future, and at expiration, deliver the spot they bought into the future to collect the difference. Some refer to this as a synthetic T-bill because the cash-and-carry investor is locking up her money for this period of time,and therefore should expect to return the rate of the loan. After all, you should have no directional risk at expiration.

Sounds easy right? If it was easy, everyone would be doing it. In fairness, a lot of people do it, however, it is not as easy as that. Why? Well,what goes into the pricing of the future? Why does this matter? Because these costs are going to be what the spot holder typically faces. Depending on the product, the costs to hold can be different. For your typical equity index investor, the futures price will embed transaction fees, taxes, the cost of money and of course dividends. For acommodity investor such as oil, the future would not include dividends, but would include the cost of storage, because if you are buying a barrel of oil now and not delivering it for a year, you have to store it somewhere. If we look at gold, you will also have to pay insurance costs because there is security involved at the facilities that store the gold. You can hopefully see that while many of these costs will be the same for most investors, some may be very different. A retail investor may not have the ability to store oil, much less the economies of scale to do it cost-effectively.

Thus, the expected return on a cash-and-carry is the Futures Price – (Spot Price + Cost of Carry). The volatility of the trade would not be the volatility of the asset per se, but instead be the volatility of the cost of carry component or how much these drivers may change over the life of the trade – interest rates if you are rolling daily, storage costs, dividends etc. You can see that mechanically, it is similar to the FX carry trade but does not involve the same directional risk. However, as a result, the expected return is often de minimus if not zero for most investors. This category of trades is also referred to as basis trading as wespoke about last time. The savvy traders will not so much look at spot vs.future, but also future vs. future where there may be a change in the embedded calculation because of changes in interest rates as we are seeing globally now.

Where it does work in the spot and futures markets are what we have seen in the crypto markets in the previous years. This is when the futures market is in contango – further out futures trade at higher prices or a premium. One who is long spot and short futures will therefore see these prices converge, either with spot moving higher or futures coming lower. This trade can be seen in other markets where contango is the typical shape of the futures curve. This is particularly the case where there may be an ETF that track the market, and must roll their front month position to the second month and does so typically a little each day. The VXX ETF and VIX futures market is an example of this. Traders on the other side of this – short futures and long spot or short second month and long front month – earn what can also be called a roll yield on this trade. The risk to these traders is a changing shape of the futures curve, which comes at a time of market duress, or at the same time Mrs. Watanabe is trying to exit FX carry trades. In times of stress, the beta of all assets moves toward 1.

If we look at the current Bitcoin or Ether futures markets, we can seemarkets that are in contango. There is a cash mismatch here as you will lock up more capital on the long side of the spot trade than you will get in your margin account on the short side. This is a reason why many crypto traders choose, or have chosen in the past, to use stablecoins to finance the long side of the trade. With some instability among some stablecoins in 2022, this could be a catalyst to an unwind of this type of carry trade that puts downward pressure on the spot price too, as these ‘market-neutral’ investors will look to exit the carry trade and even sell spot to cover losses. Also, with more capital tied up on the long-side of the trade, and interest rates rising quite rapidly in some jurisdictions, the potential profit earned on the trade is reduced as well.

There are two more iterations to consider. As you can see above, particularly in the case of Ether futures, the expected return from holding for a year is only about 1.6%. I can get more of a return in holding Fed Funds right now at 1.75%. Thus, traders who do this trade and know they can hold it, will want to use leverage to increase the returns. This can certainly help boost profits, however, if there is volatility in the shape of this curve over the life of the trade, and the trader is unable to meet margin requirements, they may be forced into liquidation.

FX carry, cash-and-carry and roll yield trades have long been the purview of hedge funds and prop traders even if they were made famous by the mythical Mrs. Watanabe. These same trades have always confused academics because of the apparently free lunch they provide, and as we know in theory, there is no such thing as a free lunch. However, the volatility of the underlying in the case of FX, or of the inputs to the cost of carry across investors in the futures version, as well as the margin needed for the trade. These trades can be the bread-and-butter of a trading portfolio in periods of low volatility. They can get squeeze out in periods of high volatility. However, they should always be something a trader is watching.

Now in crypto in particular - execution is a key risk since you have to go in and buy spot vs. then sell future. You don’t want to leave passive limit orders on both sides since especially if they are moving together it's likely one side will get filled and then you have an outright delta position. Dangerous! Especially considering crypto volatility…

This is why Paradigm has developed the first of its kind futures spreads matrix, so that investors can come in, and trade both legs of the above mentioned trade at one price! That way, you will remain delta neutral, you won’t be exposed to this outsized market risk and therefore, you will eliminate the massive leg risk by trading a two legs strategy priced as one trade by market makers, with Paradigm ensuring an atomic execution.

With the partnership now between Paradigm and FTX, traders can use the combined platform to not only monitor the opportunity set, but to execute the trade as well. They can now run spot vs futures on alts through Paradigm, cleared via FTX. Investors now have access to FTX’s spot and futures instruments across multiple coins and maturities, without any slippage on each leg by leveraging on Paradigm block trading technology.

This is yet another example of how Paradigm is moving forward to provide institutional traders with the tools needed to be successful.

Article by
Richard Excell at the University of Illinois @ExcellRichard
Richard Excell is a Clinical Assistant Professor of Finance at the University of Illinois, Gies College of Business. He retired as a Senior Portfolio Manager at Wolverine Asset Management in Chicago where he ran a global equity long/short hedge fund portfolio. Before joining WAM, he was the CIO and a partner at Satori Investment Partners. He spent the majority of his career with UBS O’Connor, where his last role was Managing Director, Senior Portfolio Manager, and Co-Head of the Fundamental Equity Market Neutral Fund. Earlier in his career, he built and managed foreign exchange, precious metals, and emerging market cash and derivatives trading businesses around the world while with O’Connor, First Chicago, BZW (Barclays Capital), and Crédit Agricole Indosuez and has lived in Japan, Hong Kong, Singapore, Switzerland, and the UK.
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