protected carry trade

[crashy]

the problem with the carry trade is downside risk. Since we are concerned only with the yield, we can sacrifice the upside possible gain by writing a call option, and use the proceeds to buy a put to protect the downside.

eg:

buy audjpy, write audjpy 82 call 1 yr out, buy 82 put 1 yr out, net small debit......collect interest risk free

has anyone ever tried this? have I overlooked anything?

[Panurgo]

Originally Posted by crashy

the problem with the carry trade is downside risk. Since we are concerned only with the yield, we can sacrifice the upside possible gain by writing a call option, and use the proceeds to buy a put to protect the downside.

eg:

buy audjpy, write audjpy 82 call 1 yr out, buy 82 put 1 yr out, net small debit......collect interest risk free

has anyone ever tried this? have I overlooked anything?

This is tipically an interest rates change bet.
Options prices are at expected interest rates discount. If you buy a 1 year Put and Sell a 1 year Call on UsdJpy you pay now the interest earned in a year holding Usd against the yen. If you do the reverse you gain now the interest lost holding the yen.
If the two interest rates will move in your favor you will gain, otherwise you will lose money.
Naturally you have to add the spot and options spreads, so if things remain unchanged you will lose money for sure.

[novice]

I think the best protection for carry trades is to use as a funding (i.e. selling) currency a currency which will likely fall.

For me the biggest risk in using the Japanese Yen as funding currency is if the Chinese Yuan is floated. If floated most likely it will rise quickly lifting the Japanese Yen with it (due to geographic proximity).

[novice]

Originally Posted by crashy

the problem with the carry trade is downside risk. Since we are concerned only with the yield, we can sacrifice the upside possible gain by writing a call option, and use the proceeds to buy a put to protect the downside.

eg:

buy audjpy, write audjpy 82 call 1 yr out, buy 82 put 1 yr out, net small debit......collect interest risk free

has anyone ever tried this? have I overlooked anything?

As I understand it LTCM used this exact strategy (i.e. interest rate arbitrage with carry trades and hedging with options)

Also as I understand it Gold Link Income Plus

http://www.incomeplus.com.au/

Uses a similar strategy. In this case they use gold as a funding currency, paying about 0.50% in interest. And Australian Dollars as a deposit currency, earning about 5% in interest. Net 4.5% positive interest. Hedge the exchange rate risk using options. Also the exchange rate risk is lower because the high correlation of gold and the Australian Dollar. The strategy seems to be working great I think I read in the paper that they made 20 million in profit last year.

[mishak]

Hello Panugro
well done professional response.

Novice, if you have an idea which currency is "likely to fall" - just sell it, never mind carry trades. You will collect much more from the ccy movement than any interest on carry trades.

[Panurgo]

Thanks Mishak.

[Nonpiker]

Your "protected carry trade" is a swap. For example, buying AUD/USD for value spot and selling it for value 12 months later. You eliminate the currency risk per say, and are just trading the interest rate differential. If interest rates change unexpectedly your swap can appreciate/depreciate in value.



I am not sure any retail shops offer this product since it is geared torwards institutions.

[ForExTractor]

Hi Crashy, you might want to find out the prices of a 1yr at-the-money call and put. Note that you'll lose all of their volatility value by the end of the year and gain from the options only enough to cover any exchange rate change. For an ATM option, volatility value should be huge.