Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Carry trades and hedging

Stephen Jen and Luca Bindelli argue in a post
at the Morgan Stanley Global Economic Forum that currency hedging
produces much of the effects that are commonly attributed to carry
trades. Jen and Luca Bindelli are absolutely right in arguing
that:

  • The magnitude of gross cross border asset positions has become
    very large.
  • Some of these cross border positions are hedged against currency
    risk using short term forward contracts.
  • A short term forward contract is economically equivalent to a
    short position in the T-Bill of one currency combined with a long
    position in the T-Bill of the other currency.
  • This position is functionally equivalent to the carry trade if the
    short position is in the low yielding currency and the long position
    is in the high yielding currency.

However, to replicate the carry trade effect, Jen and Bindelli need
to make the further assumption that the hedge ratio depends on the
cost of hedging as measured by interest rate differentials. I would
argue that the part of the hedge that depends on interest rate
differentials is a speculative position masquerading as a hedge. In
Black’s universal hedging model (“Equilibrium Exchange
Rate Hedging”, Journal of Finance, 45(3), 899-907)
the hedge ratio is a constant across all currency pairs and the
primary reason for the hedge ratio to differ from unity is
Siegel’s paradox. Even if one employs more general models, it is
difficult to see a role for interest rate differentials in determining
the optimal hedge ratio if one assumes that the forward rates are
equilibrium rates.

The assumption that forward rates are incorrect and therefore (via
interest rate parity) that interest rate differentials are irrational,
is a speculative position which is the core of the carry trade
phenomenon. It is difficult to regard this as hedging.

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