The past few decades have been too prosperous in Western countries. The book's authors believe that, sooner or later, people will have to pay for that with a painful long-term economic recession. They also predict that eventually, central banks will lose their ability to influence the situation. After that, the financial system will transform somehow. These data show that daily price changes of U.S. equities followed a random walk when measured over the whole span from 1927 to 2020. The actual variance over periods of one to thirty-two days is almost exactly the same as that implied by the daily variance (vari­ance, the square of the standard deviation, is a measure of volatility). Price changes do not, however, show a consistent pattern when measured over shorter time periods: since 1945 there has been a sharp positive serial correlation for one-day changes measured over periods of one to eleven years, but steady negative serial correlation there­after. Yet the authors are correct in claiming that daily price changes have shown a negative serial correlation since 1987. These characteristics are reflected in the options market on which the VIX is based. As both put and call options provide the same cover against market volatility, the prices of the two exhibit a phenomenon known as “put-call parity,” diverging little from each other. Robin Wigglesworth, “Jane Street: The Top Wall Street Firm ‘No One’s Heard Of,’” Financial Times, January 28, 2021.

The main reason for the surge upwards in the indicator, to unprecedented levels, is the collapse of money supply, with my estimate being that for Q1 M2 will be -2.6% year-on-year, unprecedented in modern history. carry traders are often forced to close positions when prices move against them. This necessarily means selling assets that are falling in price (or buying assets that are rising in price). Thus, the dynamics of managing carry trade risks create fire-sale effects in which initial movements in prices are often substantially amplified. The expansion of carry trades always increases liquidity; the reduction or closing of carry trades leads to liquidity contraction (p. 3, LL&C). In my own career I’ve come across it many times. As an inexperienced investment bank trader I was admonished by a senior trader for being ‘short naked gamma’: selling options in the market without the safety net of delta hedging, an especially dangerous variation of the carry trade. A few years later in 2008 I was managing a hedge fund carry strategy which lost a third of it’s notional capital in a matter of weeks. Thankfully, we had reduced it’s risk allocation for unrelated reasons, saving our clients hundreds of millions of dollars. I still trade carry today, although only as a minor component in a diversified portfolio of strategies. The financial shelves are filled with books that explain how popular carry trading has become in recent years. But none has revealed just how significant a role it plays in the global economy—until now. Interestingly, this expectation of ample liquidity runs counter to what has actually transpired when consensus views have changed and investors have sought to reposition their portfolios accordingly. In May–June 2013, when Chairman Bernanke uttered that famous word — “taper” — and raised questions about the Fed’s continuous support for markets, many investors were unable to complete their desired transactions for even the most vanilla-type securities (p. 115, El-Erian)

Help

Because volatility risk cannot be hedged in aggregate and the total amount insured seems to have grown so much, there is broad agree­ment that a future increase in volatility will produce big winners and big losers. There is, however, no consensus on whether this will simply involve a large-scale exchange of wealth between otherwise equivalent players in the market—the Pauls receiving large sums from the Peters—or if it will have serious economic, political, or social consequences. Fighting the crisis means increasing the chances of higher inflation. Since crisis risk in more salient and more immediate, it will always get priority. The logical conclusion is that inflation will not return to 2% for a sustained period. Traders do not especially care their strategies affect the operation of the market more generally, but the authors do explore this interesting facet of the carry story. I particular enjoyed their description of selling vol at short durations, then buying it at long durations. This nicely fits certain stylised facts of market behaviour: mean reversion at shorter horizons, and momentum at longer horizons. What effect does a short volatility trader have on the market? The authors are not explicit here, but a simple thought experiment may help. Consider first the delta hedging trader. If the market rises, they are forced to buy. If it falls, they must sell. Their actions will increase market volatility. Interestingly, if they have sold their option to another delta hedged trader, then their actions will be exactly mirrored by the buyer. There is zero net effect on the market, since their trades will exactly offset (assuming the same hedging strategy is used).

In this world, with the dominance of the Fed and the dollar, and the liquidity of the S&P 500 derivatives markets, the S&P 500 has evolved to become itself a carry trade at the centre of the global carry regime. A sudden crash in the S&P 500 crashes the global economy. The Fed then reacts by becoming a giant carry trader itself, replacing the private sector carry trade and ultimately reinforcing the carry regime. However the world has changed. Currently the US dollar has an interest rate more than 2% higher than that of the Euro. A carry trade where US dollar deposits are funded by Euro loans would not necessarily do badly in a global market crash. The Rise of Carry’ is the best book on the topic of ‘Carry’ I came across so far. It is excellently written, well-structured, well-researched, and thought provoking. Being a practitioner in the asset management industry who have witnessed the recent rise and crash of carry first-hand, lots of the concepts and insights in this book feel close to my heart. I sincerely recommend this book to fellow readers.

Change Website Language

Kevin has an MBA from London Business School and a BSc in Finance from the Pennsylvania State University. Tim Lee Financial instability has thus risen as the carry trade has grown. The Rise of Carry does not estimate the size of the market, for which reliable data do not seem to be available, but the authors argue convincingly that it is very large and has expanded greatly in recent years. They also point to the risk that volatility in different financial assets may be contagious: “There is also evidence of a growing correlation between currency and equity market carry, suggesting that a single global volatility risk factor may be a driver of all forms of carry in the future. If this is true, future carry crashes may impact on all asset classes at the same time.” 7 The authors do not make this distinction sufficiently clear, defining carry as a trade with ‘short exposure to volatility’. This is correct for short volatility trading, but not for FX carry where only volatility in the wrong direction is problematic. But perhaps I am being too pedantic. Higher yielding currencies are usually emerging markets. These get hurt when risk levels are elevated, whilst lower yielding currencies are normally ‘safe havens’ like the US and Japan.