Currency Carry and Funding Risks - It's all about the plumbing

 

Currency carry trades are a core strategy for many investors, but the opportunity set will be affected by funding risks. Carry trades can be profitable but there needs to be funding to conduct the quasi-arbitrage of buying high yielding currencies and selling (funding) with low yielding currencies. The plumbing matters and if there is a risk to obtaining funds, trades can be undertaken, and markets cannot move to any sort of equilibrium. The link between currency carry and funding dislocations has become more apparent since the Great Financial Crisis. 

If you want to be involved with currency carry, you have to know and follow closely the plumbing of financial markets. These financing plumbing issues have become more apparent with repo financing is Treasuries, swaps spreads, and currency trades. 

A new paper focuses on financing risks and shows that the world has changed significantly since the Great Financial Crisis regardless of liquidity provided by central banks. See "Currency Carry Trades and Global Funding Risks" by Nissinen, Suominen Filipe. They measure funding constraints as the deviation from covered interest rate parity. Funding risk will be the standard deviation of dispersion away from covered interest rate parity. Figure 2 shows the deviations from covered interest rate parity. There is a large break in the time series at the GFC. Figure 3 shows the deviation from covered interest rate parity for a long/short portfolio, and figure 4 plots the funding risk. Funding risks are associated with the equity risks of banks who will providing funding for carry, the short or low interest leg. 

Funding constraints are costly. An increase in funding risk will increase the likelihood of currency crashes and reduce the correlation between long and short legs of a currency markets. Funding increases frictions and increase the likelihood of currencies delinking. Markets become segmented when volatility affects the plumbing of funding. Analyzing classic carry trades that create long/short portfolios based on ranking of yields in forward currency markets, the researchers find that funding risk will impact future carry returns. 

This work provides a nice addition to our knowledge of currency carry trading, but more importantly, this research focuses on institutional constraints and structure on trading strategy returns. Gains and losses are associated with plumbing. An adverse change to market structure will turn good strategies on their head independent of trader skill. Trader skill is enhanced through getting around constraints or avoiding plumbing problems.