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The market's barometers of risk are showing steady improvement, just like many key instruments; however, the burden of uncertainty and threats of financial shocks are just greater now than they were a few weeks and months ago. Market participants are now left to discern whether the rebound in relatively high yield/ high risk assets is genuine or a relief rally as the eye of the storm passes.

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The market's barometers of risk are showing steady improvement, just like many key instruments; however, the burden of uncertainty and threats of financial shocks are just greater now than they were a few weeks and months ago. Market participants are now left to discern whether the rebound in relatively high yield/ high risk assets is genuine or a relief rally as the eye of the storm passes. Taking measure, we can see that most of the favored gauges for market sentiment are producing impressive improvements. Each day the equity market climbs, news headlines splash impressive statistics of its performance. For example, now at a four-week high, the S&P 500 is working on its best monthly performance in 35 years. Elsewhere, credit default swaps have dropped to their lowest levels in five years while the TED spread (the difference between the rate on the three-month US government notes and equal tenor Libor) has held close to its multi-year lows. It is the currency market however that provides the most interesting readings as reflects the seeming rebound in risk while also showing the changes that have developed between a calm in current market conditions and those from just a few years ago. The Carry Trade Index is in its most consistent rally since Spring of 2008 while the DailyFX Volatility Index extends its drop from December highs. On the other hand, it is no longer clear which currencies are safe havens and which promise outsized returns. If the outlook for health of the global financial system and economy were clear, this would not be an issue.

Indicators are frequently misinterpreted; and sometimes lose their relevance in certain market conditions. Considering the fundamental uncertainty that persists across the world, it is prudent to remain skeptical of the immediate recovery of investment confidence that will precede an influx of capital back into the speculative markets. This past week, policy officials increased their efforts to prevent what is now a severe recession from turning into a depression. Definitions for this state are loose, but its essential components are a sustained downturn in growth; high volatility in exchange rates; bankruptcies; severe restrictions on credit; and stunted trade. All of these circumstances have been met to this point; and a few of them are set to deteriorate further. At this point, the health of the global economy and the flow of money is a problem that must be addressed by every nation. However, only a few major players have made the effort with introducing massive stimulus plans, funds meant to draw out toxic debt, guarantee sound investments and bolster liquidity. This is the contention that leaders from the US and UK will bring with them to the G-20 summit on April 2nd. If there is no tangible and coordinated plan to come out of these meeting of nations, this rebound in optimism may very well collapse. With growth expected to slow further in the first half of 2009, protectionist threats rising and options running short; the future is fragile.

Is Carry Trade a Buy or a Sell? Join the DailyFX Analysts in discussing the viability of the Carry Trade strategy in the DailyFX Forum

Risk Indicators:

Definitions:


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What is the DailyFX Volatility Index:

The DailyFX Volatility Index measures the general level of volatility in the currency market. The index is a composite of the implied volatility in options underlying a basket of currencies. Our basket is equally weighed and composed of some of the most liquid currency pairs in the Foreign exchange market.

In reading this graph, whenever the DailyFX Volatility Index rises, it suggests traders expect the currency market to be more active in the coming days and weeks. Since carry trades underperform when volatility is high (due to the threat of capital losses that may overwhelm carry income), a rise in volatility is unfavorable for the strategy.

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What are Risk Reversals:

Risk reversals are the difference in volatility between similar (in expiration and relative strike levels) FX calls and put options. The measurement is calculated by finding the difference between the implied volatility of a call with a 25 Delta and a put with a 25 Delta. When Risk Reversals are skewed to the downside, it suggests volatility and therefore demand is greater for puts than for calls and traders are expecting the pair to fall; and visa versa.

We use risk reversals on AUDUSD as global interest rates have quickly fallen towards zero and the lines between safe haven and yield provided has become blurred. Australia has a historically high and responsive benchmark, making it more sensitive to current market conditions. When Risk Reversals grow more extreme to the downside, it typically reflects a demand for safety of funds - an unfavorable condition for carry.

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How are Rate Expectations calculated:

Forecasting rate decisions is notoriously speculative, yet the market is typically very efficient at predicting rate movements (and many economists and analysts even believe market prices influence policy decisions). To take advantage of the collective wisdom of the market in forecasting rate decisions, we will use a combination of long and short-term, risk-free interest rate assets to determine the cumulative movement the Reserve Bank of Australia (RBA) will make over the coming 12 months. We have chosen the RBA as the Australian dollar is one of few currencies, still considered a high yielders.

To read this chart, any positive number represents an expected firming in the Australian benchmark lending rate over the coming year with each point representing one basis point change. When rate expectations rise, the carry differential is expected to increase and carry trades return improves.

Additional Information

What is a Carry Trade
All that is needed to understand the carry trade concept is a basic knowledge of foreign exchange and interest rates differentials. Each currency has a different interest rate attached to it determined partly by policy authorities and partly by market demand. When taking a foreign exchange position a trader holds long position one currency and short position in another. Each day, the trader will collect the interest on the long side of their trade and pay the interest on the short side. If the interest rate on the purchased currency is higher than that of the sold currency, the result is a net inflow of interest. If the sold currency's interest rate is greater than the purchased currency's rate, the trader must pay the net interest.

Carry Trade As A Strategy
For many years, money managers and banks have utilized the inflow and outflow of yield to collect consistent income in times of low volatility and high risk appetite. Holding only one or two currency pairs would invite considerable idiosyncratic risk (or risk related to those few pairs held); so traders create portfolios of various carry trade pairs to diversify risk from any single pair and isolate exposure to demand for yield. However, even with risk diversified away from any one pair, a carry basket is still exposed to those conditions that render this yield seeking strategy undesirable, such as: high volatility, small interest rate differentials or a general aversion to risk. Therefore, the carry trade will consistently collect an interest income, but there are still situation when the carry trade can face large drawdowns in certain market conditions. As such, a trader needs to decide when it is time to underweight or overweight their carry trade exposure.

Written by: John Kicklighter, Currency Strategist for DailyFX.com.
Questions? Comments? You can send them to John at jkicklighter@dailyfx.com.