Sunday, July 20, 2008

Risk aversion, the VIX index and the carry trade

Watching carry trades this month would suggest that there is no problem with risk aversion in the currency markets. High yielders are doing well like the best of carry times. This is especially surprising given some of the signals that have traditionally been used to measure risk aversion in the market. The general view is that when risk aversion increases there will be a home bias that will keep funds from moving into carry strategies. For example, the VIX volatility index has moved above 30 which has usually been a sign of heightened risk aversion and an equity sell-off, yet has done well even with the risk jump.

Carry trade dynamics may be changing. In a risky world of credit, trading sovereign credit through carry trades may be less risky than the credit risk of buying debt from a corporation.

Sovereign risk for many high yielders has diminished significantly over the last few years. While sovereign ratings have increased, they may not actually reflect the true positive developments in many of these countries. Current account balances for many emerging markets are in surplus and the economies of emerging market countries also seem less linked with the US. The linked effect for emerging market, expected in the second half of 2007, never truly materialized.

Instead of placing more money in US debt even at the more attractive current spreads, the diversification benefit from carry across a number of countries may be a more controlled bet. While carry trades have underperformed in the last year and are generally correlated with equity returns, the relative underperformance has not been as great as what the markets have seen with global equity indices.

The mood for how the market looks at carry may be changing which means the link with equities may be over and the strategy is viewed as an more effective alternative to corporate spread risk when there is heightened credit concerns.

No comments: