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CurrencyCast

CurrencyCast is a treasury podcast series from currency management experts. In each episode, we look at the pressing foreign exchange (FX) risk issues facing treasurers and CFOs today and help them identify the potential gaps in their FX risk management strategy.

Corporate FX Hedging Beyond the Carry Trade with Daisy Andrew from BNPP London (S9 E2)

October 2, 2024
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The Carry Trade: A Double-Edged Sword

Is your company prepared for a market shock? In our latest episode of CurrencyCast, we interviewed Daisy Andrew, IRFX Corporate Sales from BNP Paribas London, to discuss corporate FX hedging, the carry trade and effective risk management strategies in volatile episodes. In this blog, we present some takeaways on the carry trade and what corporate treasurers need to understand to manage the FX exposure.

Understanding the Carry Trade

The carry trade, a popular investment strategy, where an investor borrows capital at a lower interest rate to invest in assets with potentially higher returns. While it can offer attractive returns, it also carries significant risks. In foreign exchange (forex or FX) markets, it's defined as borrowing in a low-interest rate currency (the funding currency) and investing in higher-yielding assets denominated in another currency (the investment currency), aiming to profit from the spread.

At its core, the carry trade capitalises on interest rate differentials between different currencies. For example, a trader might borrow Japanese yen at a near-zero interest rate and invest the proceeds in Mexican pesos, which typically offer higher interest rates. The goal is to earn a profit on the interest rate differential.

Corporate treasurers must carefully consider the implications of the carry trade when managing their foreign exchange (FX) exposure. The carry trade is not without its risks. If the exchange rate moves against the investor, the potential profits can quickly turn into losses. Additionally, currency volatility can increase during periods of economic uncertainty or geopolitical tensions, further exacerbating the risks associated with the carry trade.

The Summer 2024 Example

In August 2024, global financial markets experienced significant volatility, when under political pressure to counteract a rise in inflation, the Bank of Japan (BOJ) raised interest rates and reduced bond purchases, catching many investors off guard. As the yen strengthened against the MXN, investors were compelled to unwind their carry trade positions, leading to a surge in demand for yen and a sell-off in riskier assets.

This wiped out the 10% interest rate differential and led to significant losses for investors who had engaged in yen carry trades. Daisy Andrew advises corporates to carefully consider the potential risks and explore alternative strategies to mitigate the impact of currency fluctuations.

If we look at the numbers from this episode, in early August 2024, net short positions in yen futures by “speculative traders” had reached historical peaks of around ¥2 trillion (or about $14 billion). As the Bank for International Settlements argues, currency futures are only "the tip of the iceberg" (*). Over-the-counter FX derivatives bear much larger carry trade positions.

“FX carry trades were hit hard by the deleveraging pressures. Various estimates based on both on- and off-balance sheet activity yield a rough middle ballpark of ¥40 trillion ($250 billion) going into the event, which, if anything, is biassed down due to data gaps” — BIS

To what extent should corporate FX managers pay attention? At Kantox, our positions is always to take a step back and let data-driven automation solutions drive your decisions to be more strategic and avoid biased speculative behaviour.

Corporate Treasurers: A Different Perspective

While the basic mechanics of the carry trade are the same for both corporates and investors, their approaches can differ:

  • Investors: For investors, the carry trade can be an attractive way to generate returns. They are typically more willing to accept the associated risks, as long as the potential rewards outweigh them.
  • Corporates: Corporate treasurers shouldn't aim to make money from carry trades but instead look to take advantage of favourable forward points to hedge to longer dates or top up existing hedges. However, with increased rate divergence, corporates face challenges when hedging high-carry currencies.

The Carry Trade and FX Risk Management

Some techniques that can be used in FX corporate risk management to mitigate the impact of the negative carry costs is forward point optimisation. Corporate treasurers that act as FX risk managers can look at the interest rate differentials to manage the forward points.

Forward points optimisation allows currency managers to take advantage of differences between spot and forward currency rates, themselves driven by the interaction between FX and interest rates. The fact that currencies trade against each other at various degrees of forward premium/discount plays a major role in FX risk management.

There are two key rules of thumb for optimising forward points in currency hedging: 

  • With favourable forward points. Anticipate hedge execution as much as possible. The hedge rate captures the positive impact of interest rate differentials. 
  • With unfavourable forward points. Delay hedge execution as much as possible when carry costs are high with conditional FX orders. Using automated solutions treasurers can set a range of limits and stop loss orders that hold off from hedging currencies with high carry costs. And incorporate a range of worst-case scenarios depending on your risk appetite. The hedge rate improves as hedging is postponed.

It gives Treasurers time also to update their forecasts in some setups, which could even be beneficial from the point of view of collateral management. And uncover more netting opportunities.

Daisy also suggested another alternative, which is incorporating some optionality into the hedging portfolio. She believes we are still in a low volatility environment, so for corporates who do have the flexibility of incorporating options as hedging instruments could be considered.

Lessons for Corporate Treasurers

Given the last five or so years and the volatility that we saw over the summer, the main learning for corporate treasurers is that they have to remain very flexible during volatile periods and not require these crazy market events to change their trading pattern. It is an interesting time to consider automation because the last five years of data have almost already been stress-tested.

So if you are incorporating five years' worth of data into your hedging policy, leverage automated FX management solutions to prepare a hedging strategy better suited for any kind of super volatile period to come up.

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