Previously, we explored basic mechanics of FX carry trades and reasons behind the existence of the risk premiums. Carry trades in managed currencies can be profitable, yet inherently very risky (think of fat-tail events).
In this post, we will use a carry/vol framework to assess viability of carry trades in G20 currencies (see attached table). We are looking for currencies that exhibit high IR differential with a low probability of adverse FX movements. This probability can be analyzed in multiple ways:
1️⃣ Historical and Implied FX Volatility
Historical FX volatility is a go-to measure for assessing the risk of adverse currency movement. The drawback is that it is backward-looking and not well suited for pegged/managed currencies or currencies with large spot/vol correlations (which are typical for emerging markets). An alternative measure is volatility implied from FX options, because incorporates forward-looking market consensus.
2️⃣ Risk Reversals
Positive risk reversals indicate that currency is likely to experience high volatility, if it depreciates. Risk reversals tend to be higher for currencies with asymmetric, event-driven, or political risks. This applies to both managed and free-floating currencies.
Pegged (AED, SAR, HKD) or managed (TWD, CNY, SGD, MYR, INR, and to some extent also JPY) currencies typically offer lower volatility when measured using historical data or implied from ATM option volatilities. This can sometimes mislead traders into a false sense of security when executing carry trades.
It is not a coincidence that most recent headlines were made in managed currencies such as JPY and TWD.
(See graph showing managed currencies in red and free-floating in green)
🟩Free-Floating Currencies
Free-floating currencies such as GBP, AUD, or EUR offer less potential for profitable carry trades, since their central banks manage interest rates in a fashion resembling synchronized swimming, leaving their FX movements to market forces. On a flip side, these currencies exhibit less tail risk.
Historical FX volatility is a go-to measure for assessing the risk of adverse currency movement. The drawback is that it is backward-looking and not well suited for pegged/managed currencies or currencies with large spot/vol correlations (which are typical for emerging markets). An alternative measure is volatility implied from FX options, because incorporates forward-looking market consensus.
2️⃣ Risk Reversals
Positive risk reversals indicate that currency is likely to experience high volatility, if it depreciates. Risk reversals tend to be higher for currencies with asymmetric, event-driven, or political risks. This applies to both managed and free-floating currencies.
🟥Managed Currencies
Pegged (AED, SAR, HKD) or managed (TWD, CNY, SGD, MYR, INR, and to some extent also JPY) currencies typically offer lower volatility when measured using historical data or implied from ATM option volatilities. This can sometimes mislead traders into a false sense of security when executing carry trades.
It is not a coincidence that most recent headlines were made in managed currencies such as JPY and TWD.
(See graph showing managed currencies in red and free-floating in green)
🟩Free-Floating Currencies
Free-floating currencies such as GBP, AUD, or EUR offer less potential for profitable carry trades, since their central banks manage interest rates in a fashion resembling synchronized swimming, leaving their FX movements to market forces. On a flip side, these currencies exhibit less tail risk.
🧨FX Carry and Political Risk
While currencies like the Turkish lira (TRY), Russian ruble (RUB), and Brazilian real (BRL) may initially appear attractive for carry trades, they carry significant political risk that can undermine their appeal. In particular, the TRY is prone to persistent depreciation, driven by the country's high inflation environment. As a result, purchasing power parity considerations are essential when forecasting its future trajectory.
Attached figure shows evolution of TRY between Oct 2024 and Oct 2025. The actual depreciation is around 20% due to inflation, while the interest rate differential is above 30%.
It is worth noting that the resulting 10% premium exists for a good reason - FX returns are not normally distributed, and there is significant fat-tail risk due to political events. For example, consider the 19/3/2025 arrest of Istanbul's Mayor E. İmamoğlu, which resulted in a 5% drop in value within a single day.
While currencies like the Turkish lira (TRY), Russian ruble (RUB), and Brazilian real (BRL) may initially appear attractive for carry trades, they carry significant political risk that can undermine their appeal. In particular, the TRY is prone to persistent depreciation, driven by the country's high inflation environment. As a result, purchasing power parity considerations are essential when forecasting its future trajectory.
Attached figure shows evolution of TRY between Oct 2024 and Oct 2025. The actual depreciation is around 20% due to inflation, while the interest rate differential is above 30%.
It is worth noting that the resulting 10% premium exists for a good reason - FX returns are not normally distributed, and there is significant fat-tail risk due to political events. For example, consider the 19/3/2025 arrest of Istanbul's Mayor E. İmamoğlu, which resulted in a 5% drop in value within a single day.
⚠️Disclaimer: This is personal post, no investment advice. Please read full disclaimer in the footer.
No comments:
Post a Comment